Free Market Efficiency - Essay Example

Free Market Efficiency The issue of resource allocation in an economy and the efficiency or inefficiency of free markets is still among the hotly contested debates in political and economic circles. The practical reality is that most markets are prone to encounter inefficiencies influenced by different factors. The purpose of this paper is to explain the economic efficiency of free markets with emphasis on the optimal approach of resource distribution (Mankiw, 2009:148). The paper explores the idea behind free markets and their occurrence and the economic pathology and efficiency of free markets. In addition, the paper also focuses on the criticism and arguments surrounding the free market concept. The efficiency of free markets surrounds the effectiveness of an economy in the allocation of resources. The efficiency of a free market is dependant on satisfaction of several conditions that permit the agents in that economy to trade freely and attain the market equilibrium in quantity and price. For the purpose of this paper, a free market is one that has negligible government interference, or no such interference (Argelis & Pitelis, 2008: 1). With this in mind, we may define a free market as a market where the agents engage in selling and buying activities on own consent, without any legal compulsion. The prices at which a trade transaction takes place, or the quantities traded are not under control (direct or indirect) of third parties in the market. In essence, this implies that the market operates without legal restrictions or regulations. Simply, a free market is one where buyers decide freely the commodities to buy and their quantities at the prices of the sellers and sellers choose freely the commodities they are willing to manufacture and sell at their price that they decide to sell. The first welfare theorem or the invisible hand proposes that a free market provides a channel through which an economic system is able to reach the ideal level of production. According to Adam Smith in The Wealth of Nations, the different traders, like butchers and brewers, do not offer their services out of benevolence, but with a consideration of their own gains (Chang, 2002:5). Kenneth Arrow and Gerald Debreu later mathematically confirmed this theorem, indicating that in the event that all possible gains are exhausted from the exchange, then the free market attains an equilibrium equivalent to the Pareto efficiency in allocation of resources. In economics, the allocation of resources is Pareto efficient if there is no other feasible allocation preference by one party, and which the other party equally likes, therefore making any further mutual benefiting allocation impossible (Hayek, 1945). For instance, party A and party B engage in a trade exchange. After several exchanges with emphasis on their level of endowment, party A and party B will reach a position on the curve (B and C), which is the Pareto optimal point of resource allocation (Lott, 2007: 82). The curve demonstrates the dual benefits of both parties for both reaching an equilibrium benefit of transfer and guiding the economy towards an outcome that observes the Pareto efficiency. Fig 1: Pareto optimality graph. From http://www.google.com/imgres?imgurl=http://pmbook.ce.cmu.edu/images/fig8_1.gif&imgrefurl=http://pmbook.ce.cmu.edu/08_construction_pricing_and_conctracting.html&usg=__d69xypDoP0EqqL9D0orgPd46Ezw=&h=399&w=404&sz=5&hl=en&start=3&sig2=s1ZXuuc1Dtp3tLmn-opTVA&zoom=1&tbnid=AORY7mH4F1EvoM:&tbnh=122&tbnw=124&ei=uZDpTrifAsqZiQfMnYWyBw&um=1&itbs=1 The Pareto-efficient outcome is only attainable on the certain conditions that are generally not applicable in practice, despite the mathematical proof by Kenneth Arrow and Gerald Debreu (Mankiw, 2009:153). These conditions include, but not limited to, imperfect competition like a monopoly, inevitable provision of public goods, presence of externalities, negligible transaction costs that are difficult to achieve, and social priorities that often favor a particular distribution of resources. A free market, according to Kenneth Arrow and Gerald Debreu observation, may only reach the Pareto efficiency on satisfaction of certain restrictive conditions that are impractical in application. Nonetheless, this not normally the case in economies that follow the principle of central planning due to the imperfect information in the economy, and the poor incentives in place to set to the ideal levels of production and pricing (Hayek, 1937). However, a decentralized economic system experiences a certain amount of distortion where the marginal social benefits and marginal social costs do not match, a situation that may lead to market failure, which in turn affects the quality and efficiency of a free market resource allocation (Nell, 2009: 16). These distortions include imperfect competition, externalities, public goods, asymmetrical or incomplete information, and tariff and taxes distortion. Under imperfect competition, it is general knowledge that a free market may operate in varying degrees of supplier control and participation. A perfect competitive market enjoys prices and quantities shaped by market forces, resulting in normal profits (Hayek, 1945). Such a market is very rare or practically impossible, considering the fact that many free markets allow a certain degree of imperfect competition that allows some sellers and buyers to exercise some form of output or price control in the case examples of monopolies, monpsonies, oligopolies, oligopsonies, and general monopolistic competition. Extreme scenarios on production control, such forms of imperfect competition like monopolies, or other divergent forms, may result in excessively high prices in the market, leading to an economic concept referred to as inefficient Dead Weight Loss in the economy and the general society (Nell, 2009: 73). The other two requirements not empirically observed are condition that a market must incorporate all varieties of goods, which are practically impossible, and the other condition that transactions costs must remain negligible, a difficult task considering the fact that some costs incurred in performing trade. In addition, a natural monopoly might be more efficient in the end considering the declining of average operations cost. The most viable solution to contain the effect of a monopoly as a barrier to market efficiency may be to establish anti-trust policies, or rater have these free markets regulated by the government. Public goods result in market inefficiency resulting from the antiquated regulations and thus suffer from the free-rider problem. Governments all over the world have been on the idea of deregulating businesses and industries considered public in the efforts to enhance their efficiency (Lott, 2007: 79). Nonetheless, other sensitive areas remain under government control, like nuclear power and defense, as the privatization of these sectors would create a free market that could undermine the quality or level of the service in the sectors. However, public goods, like streetlamps or transportation systems, experience the free-rider issue that conflict the interests of the common good and individual interest (Argelis & Pitelis, 2008: 8). A prime example is the issue of commons. Inefficiencies resulting from such public goods may be solved (partly) by the imposition of taxes to the citizens with the consideration that the payment system reflects the amount approximately similar t the cost of individual utilization of the public goods. The problem with this remedy is the difficulty associated with the measurement of utility of a public good. Externalities arise when a given market does not consider the impacts of other economic activities apart from the prices. Such a case would be either positive or negative, but since the free market is incapable of inducing market agents to take account of such indirect effects. As such, inefficiencies occur from social costs production or consumption benefits that result from marginal social costs or benefits, or the variance in marginal private costs or benefits (Hayek, 1937). Nonetheless, corrective measures may be taken against such externalities that affect all the individuals in the activity, though such a solution may be seldom, or non-existent. Such corrective measures include taxes or subsidies, state regulations, and property rights that provide a clear guideline in cases of uncertain ownership. The property rights measure is usually applicable where the aim is to reduce any uncertainties that emerge from cases of ambiguous investments, ownership, or requisition of property. It is a generally acceptable fact in economics that most markets experience the problem of asymmetrical or incomplete information, like the case of classical lemons in the sale of used cars. This results in the implementation of output and price decisions based on the incomplete or asymmetrical information, a situation that ends in the implementation of private decisions that do not reflect the common interest of the society as a whole (Mankiw, 2009:161). In free market principles, taxation and tariffs affect the manner in the making of prices and outputs decisions. This simply means that taxation and tariffs affect the competitive equilibrium of the market through the adjustment of prices between marginal social costs and marginal private costs, creating inefficiencies. In this regard therefore, a government intending to impose taxes and tariffs must make such a decision based on the cost benefit analysis regarding the balance between equity of distribution with emphasis on the innate levels of endowed resources and the inefficiency costs resulting from the imposition of taxes. Efficient markets may be undesirable. In economics, allocative efficiency, which is the principle contributor to market efficiency, is a source of attraction for economics, but does not necessarily mean that it is the optimal outcome of desire (Mankiw 2008: 150). Free market efficiency and equal distribution are the two distinct concepts that may make a market to be efficient and at the same time be sub-optimal. According to the second theorem of welfare economics, any allocation on the Pareto efficiency curve is in essence a competitive equilibrium. John Stuart Mill, stating that resource distribution may be efficient, but not necessarily desirable as the issue of social optimality is relative, better explains this theorem. Referring back to our earlier graph on the Pareto optimality, points B and C both illustrate effective competition equilibrium along the curve. Despite the equality in efficiency, points B and C may be have different levels of perception on social equity (Friedman, 2003: 125). Therefore, there exist two concepts: horizontal equity, which symbolizes the treatment of all agents as equal and vertical equity where there is considerable fairness in the difference between the poor and the rich. The normative question concerning the issue of distribution in efficient markets is politicized; a fact that makes the practical existence of such an economy that leaves income distribution to the market place rare if not possible. This is because majority of the key players favor welfare state because the underlying norms of equality and the commitment to the same are strong and play a crucial role in the public policy debate context (Mankiw, 2009:154). Therefore, despite allocative efficiency in some free markets, a government may decide to implement rationing, oversupply, or queuing in distribution over market clearing quantity and price in the case where the public perceives a efficient policy to be unfair. An additional (and interesting) observation is that some proponents of the welfare state argue that it is not only based on equity, but also efficiency, as an absence of such provisions of minimum standards of living will cause externalities like poor public health, crime, and unemployment. Nonetheless, some critics say that the costs involved in providing such commodities and limiting them contributes to the creation of some forms of externalities in their own right (Hayek, 1945). In addition, issues only arise from the firms’ incapability of creating an economic profit able to suppress their viability. As such, any economy would be influenced negatively if the profits realized from firms were not re-invested back to the economy in another form of improved service or product for all the agents or as a profit for other workers, since such firms constitute an essential cycle of investment between industry and households. From this observation, it is appropriate to determine the extent of which a market agent benefits from an economy, which proves to be difficult as there does not exist the objective measure of cardinal utility. Below is an illustration of the welfare function. W=u1+u2 u1 and u2 are utility functions, W is the overall welfare function. W(u)=?i?n ai ui i?n indicates a special interest. W(u)=Min {u1….un} the ideal egalitarian social welfare function is obtained from maximizing W (Friedman,2003:97). However, even with the idea of maximizing the minimum welfare function, it is difficult to determine the poorest individual in the society. Additionally, the cardinal utility value is still not measurable. Generally, there are problems associate with making comments or statements about the level or size of changes in individual welfare in order to obtain an average utility of individuals with dissimilar marginal utility levels (Hayek, 1945). The most common method in determination of social choices is the ‘majority rule’, which is not consistent in its application. Therefore, the only option available is subjective assumptions, whose application in the social welfare function is explicit and implicit under efficiency, with the objectives of improving the distribution of resources. The social optimality of an economy under a democracy is best highlighted in Arrow’s Implausible Theorem of the 1940s. According to the theorem, Arrow states three social preference properties that must be identical to a member of the society that the social welfare theorem satisfies (Hayek, 1937). Thus, we may effectively discount the voting system of democracy as an imperfect model regarding social economic welfare since it provides three or more options. From the above discussion, it is conclusive that a free market allocates resources in the most efficient manner, as it maximizes the total surplus, which is the summation function of producer surplus and consumer surplus. Consumer surplus is the result of subtracting the price at which the buyer is willing to pay from the price at which that buyer actually pays (Mankiw 2008: 150). On the other hand, producer surplus is the value obtained from the subtraction of the amount received from buyers by the producer from the cost to sellers. Since the amount paid and the amount received are equal, it then follows that the total surplus is the value obtained from subtracting value to buyers from cost to sellers. In economics, any form of allocation that maximizes such a surplus is efficient. Moreover, according to the discussion above, it is widely understood that an efficient allocation of resources is not necessarily fair, a concept known as division of equity. In addition, any price that differs from the equilibrium price of the market will reduce the value of total surplus. Now, because the free market allows the free movement of output and prices, an equilibrium price is reached, allowing such a market to maximize surplus. This, in essence, means that a free market will produce an efficient allocation of resources (Lott, 2007: 38). In can thus be conclusively be stated that a free market in equilibrium will allocate the supply of commodities to the buyers who offer the highest value (their willingness to pay), allocate the demand for commodities to the sellers who may produce at the lowest costs possible, and produce the ideal commodity quantity that maximizes the surplus (Mankiw 2008: 150). With the assumption that there exists competition in the free market though with negligible externalities in the trade transaction, the free market outcome is efficient and will benefit both the buyer and the seller. However, the outcome may or may not be fair, depending on the prevailing distribution of wealth and income. In addition, the free market equilibrium takes some time before realization, particularly in new businesses, and the externalities may affect the forecast equilibrium output and price. Bibliography Argelis, G. and C. Pitelis. 2008. Global Finance and Systemic Instability, Contributions to Political Economy. Oxford Journals (27): 1-11. Reprinted at : http://cpe.oxfordjournals.org/content/27/1/1.extract Chang, Ha-Joon. 2002. Breaking the Mould: An Institutionalist Political Economy Alternative to the Neo-Liberal Theory of the Market and the State. Cambridge Journal of Economics, Vol. 26 (5). Hayek, F. 1937. Economics and Knowledge. Economica (IV), reprinted at: http://www.virtualschool.edu/mon/Economics/HayekEconomicsAndKnowledge.html Hayek, F. 1945. The Use of Knowledge in Society. American Economic Review (35):4, 519-530. reprinted at: http://virtualschool.edu/mon/Economics/HayekUseOfKnowledge.html Lott, J. 2007. Freedomnomics: Why the Free Market Works and Other Half-Baked Theories Don’t. Washington DC: Regnery Publishing Inc. Mankiw, N. G. 2008. Principles of Economics. Mason, OH: South-Western Cengage Learning. Print. Mankiw, N. G. 2009. Principles of Microeconomics. Mason, OH: South-Western Cengage Learning. Print. Nell, E. 2009. Free market Conservatism: A Critique of Theory and Practice. New York: Taylor & Francis. Friedman, K. S. 2003. Myths of the Free Market. New York: Algora Publishing. Read More