Efficient Allocation of Resources in Market - Term Paper Example

 «Efficient Allocation of Resources in Market» The purpose of this assignment is to focus on some fundamental economic concepts such as the Welfare economics theorem. The importance of the First Welfare Economics theorem is discussed in detail in the paper with an emphasis on the problem of second best in the first part of the answer. This part also explains the concept of Pareto efficiency and discusses how the theory of the second best might contradict the first welfare theorem of economics. The second part of the essay deals with the concept of market failure and discusses two cases where market failures do not let the market supply meet the market demand. Also, it provides certain measures that may be taken by the governments to deal with the problem of market failures with a detailed explanation of the validity of each measure. The First Welfare Theorem of Economics The First Welfare Theorem of Economics, according to Hens and Reiger (2010), implies that in a complete financial market, the allocation of consumption streams in any market equilibrium is Pareto efficient. It is important here to understand the concept of Pareto efficiency. Pareto efficiency, according to Gordon (2008), is a notion of efficiency that determines the allocation of resources in a market. Generally in a market, the endowments and the consumption patterns of each individual differs. This means that there are a set of different alternatives for every individual when it comes to allocation of goods and outcomes. Because of the difference in the allocation of goods and resources for each individual, they might want to change from one allocation to the other. The concept of changing from one allocation to the other is known as a Pareto optimal move. Pareto efficiency, on the other hand, is a situation in which switching from one allocation of resources to another, one person cannot be made better off without making the other worse off. This means that at the Pareto efficient point, the allocation of resources is done in a manner that cannot be improved further (at least by the free market), even if it is not a socially desirable level of allocation. According to the above mentioned explanation of the concept of Pareto efficiency, the first welfare theorem means that whenever there are free markets present, the resources will be allocated in such a manner that it will be impossible to make one person better off without making the other worse off, as Mankiw (2003) relates. This concept is very similar to the ‘Invisible Hand’ of Adam Smith in which he regarded the market forces as an essential source of an efficient allocation of resources. Overall, the theorem implies that if there is no intervention from the government or from any other source, and the free market is allowed to operate, the market supply would meet the market demand. Since the theorem deals with the free market forces, the assumptions that are taken here are a large number of buyers and sellers, the price taking nature of firms, and complete information. This means that the theorem would not hold in the presence of imperfect competition or incomplete markets. The theorem also makes use of the local non satiated preferences assumption. Local non satiation preferences property implies that for every consumption bundle, there is always another one bundle that is close to it and that may be preferred over the initial bundle. This means that according to the first welfare theorem, each consumption bundle always has another bundle that is preferred to it. The more formal statement of the theorem is that if the preferences of the individuals are locally non satiated, and if X, Y and P is a price equilibrium with transfers, then the allocation that might be achieved through the market forces would be X and Y, that is the Pareto efficient level of allocation. This means that at the X and Y level of output, no one can be made better off without making the other worse off. The Problem of Second Best In welfare economics, the theory of the problem of the second best refers to a situation when one or more of the optimality conditions are not met. When optimality conditions are not met, the Pareto optimality condition according to the first welfare theorem of economics cannot be achieved. However, according to the theory of Second Best, if one optimality condition in a market cannot be satisfied, it is possible that the next best solution is adopted that may result in the changing of variables that are otherwise assumed optimal. The theory of second best implies that if one market is in disequilibrium or is suffering from a market failure, the other market, in a move towards greater perfection, might decrease its efficiency, as Keunne (2000) relates. Consequently, the efficiency of one market cannot be achieved if there is a market failure in another. Hence, neither of the two (if there are two markets in the economy) benefit from a Pareto efficient allocation. According to economic theory, this problem can be solved by allowing the market forces to allocate the resources itself. When there is no government intervention, the markets can distribute and allocate resources in a way that would cancel or neutralize the effect of the market imperfections. However this might not be true practically. Government intervention might be essential for the solution of the problem of the second best. This is so because the market failures actually exist because the markets are allowed to continue operating. The theoretical perspective that, if no intervention is there both the markets will achieve Pareto optimality, is not valid in reality. If that was possible, the markets would not have been suffering in the first place. Only the government alone can ensure that one market does not affect the other or even if one market does affect the other, the government can make certain that the market failure that existed before are removed from the markets. This leads to a contradiction. As mentioned earlier, the first welfare theorem of economics states that Pareto efficiency or optimality can only be achieved if the market is allowed to work freely. But in the theory of the second best, the government needs to be present to ensure that because of a market failure in one market, the desired efficiency of another is not in any way hindered. So the role of the government here is to help achieve an efficient allocation of resources where one person is not made better off without reducing the welfare of another. Hence, in this case, the government is the agent that helps the market achieve an efficient allocation of resources. This concept contradicts the earlier idea that the markets can only achieve Pareto optimality if markets, without government intervention, are allowed to operate. Now the paper moves on to the second part that is the one based on market failures. Market failure According to Cowen (1991), a market failure might refer to a situation whereby the allocation of resources in a free market is not efficient. This means that the market gains for some of the participants and agents (buyers and sellers) of the market would enjoy benefits that would outweigh their losses even if some agents have to lose because of the new allocation of resources. Market failures are generally viewed as scenarios where the self interest of one person (or one firm in more general terms) causes the society to optimise at a level that is not entirely efficient or that can be improved further. According to economic theory, there are usually three causes for market failures when it comes to the concept of Pareto efficiency. Firstly, as Lipsey and Harbury (1992) relate, certain agents in a market might have the market power. This power might help them to block the gains that can be achieved by others and lead to a situation of imperfect competition. Monopolies and oligopolies are examples of situations where the power of one (or more) firms causes them to have ultimate power over the market. Monopolies generally produce at a level that is below the optimum level of production. This means that the quantity is restricted to get a higher price which further means that some of the buyers might not have the chance to buy the product because of non availability. Market failures might also arise due to the presence of externalities. This, as will be explained in much detail later, causes, as Estrin et al. (2008) relate, the social marginal cost to exceed beyond the private marginal cost such that the losses to a certain firm are far less than the costs that are incurred by the society as a consequence of the production process. Also, in some instances, the social marginal benefit might be greater than the private marginal benefit too. Market failures may also exist because of the certain nature of a product. For instance, a good might behave like public goods despite the fact that there may be transaction costs and agency problems associated with them. There may be free rider problems in this case too. This would lead to an overall inefficiency and a resultant market failure. Now that the concept of market failure has been discussed to some extent, it is important to move onto two examples where the market failures might exist. Negative externalities According to Ferguson (2004), a market failure may arise when there are negative externalities present in the market. Negative externalities are the externalities that are associated with the production of certain products e.g. the air pollution that is caused by different steel industries. In the case of negative externalities, the ones who are the problem-creators are not penalized while the affectees are not compensated. In the example of the air pollution caused by industries, the steel firm owners are usually not penalized despite affecting the air for the people who live around the industry. This implies that the social marginal cost (or the cost to the society) is higher than the private marginal cost (or the cost of the steel firm only). Hence there is disequilibrium in the economy. Baumgartner (2000) reveals that the presence of the negative externalities causes the First and the Second Welfare Economics Theorems to run into difficulties, especially in the case of a non convex production possibility set. With the negative externalities present in the system, the first welfare theorem breaks down and a general competition is, in general, not Pareto optimal anymore. This means that the allocation of the consumption and resources in not Pareto efficient which further implies that the market does not optimise at the maximum efficient level that is at a point where one person cannot be made better off without making the other worse off. Even in the case of negative externalities present in a convex possibility production set, Pareto efficient allocation of resources cannot be achieved. However things are different in this case because the remedy to such a problem is usually the imposition of taxes. Taxes are not just a source of revenue for the government, but they also ensure that the problem creators (such as the steel firm owners) are forced to pay for the costs that they cause to the society in general. The revenue earned from taxes is used as government expenditure so the affectees are, in a way, compensated. However the imposition of taxes can only work when the production possibility set is convex. According to Baumgartner (2000), the imposing of taxes in a non convex production possibility set might actually further worsen the situation rather than remedying it. Regulation may be used instead to limit the units of production of the industries. This would ensure an optimal level of the allocation of resources. Imperfect competition According to Stiglitz (1991), imperfect competition might arise when any of the assumptions of a perfect competition are violated. A perfect competition in general has many buyers and sellers, homogeneity of the products, no barriers to entry and exit etc. Hence, in a perfectly competitive market, the price of any good equals the Average Revenue and the Marginal Revenue derived from the product. This means that the demand curve is horizontal (or perfectly elastic). A perfectly competitive market leads to an allocation of resources that is Pareto optimal. In reality, the assumptions of perfect competition might not be present entirely, but a competitive environment may exist. A violation of the assumptions of a competitive market means that the number of buyers and sellers might not be large. This is a situation which is usually existent when a monopoly operates in the market. The consumers in this case are large but there is only one producer (in ideal terms). The monopoly of one person makes him/her a price maker in contrast to a price taker in the competitive market. Hence he/ she charges at a price where his/her profits are maximised, that is when the Marginal Cost of a unit of production equals the Marginal Benefit derived from the selling of the unit of production. Consequently, there is an under production of the good because the quantity is compromised to achieve greater profits through an increase in the price. This leads to a situation of imperfect competition. There are no set rules of how to deal with the problem of imperfect competition. The emphasis of governments generally in this case is to introduce any alternative that may increase the competitiveness of the industry. For instance, through regulation, monopolies might be forced to produce a given quantity of goods which may increase the competitiveness (with the reduction in prices) and also cause reduced dead weight loss. The same problem can be dealt with, by the introduction of price ceilings. With price ceilings, the monopolies might not be able to charge more than a certain amount. In order to be on equilibrium level of output, monopolies might increase their production and so on. Conclusion To conclude, the First welfare theorem implies that a Pareto optimal level of allocation cannot be achieved if there is government intervention present in the market. On the contrary, it needs the free market forces to achieve maximum efficiency. This concept may be applicable in theory but when it comes to the application of the theorem in the real world, it may result into a number of contradictions. The theory of second best is an example because it would require government intervention to deal with the decreased level of efficiency when the market forces cannot help. Market failures are also a reason why the market forces cannot be entirely reliable when it comes to the efficient allocation of resources. Market failures exist because the free market forces are not able to allocate resources in the best manner possible. In order to deal with market failures, government intervention is essential because only the government can impose different regulations like the price ceiling mechanisms, taxation etc. All in all, market forces might achieve an efficient allocation of resources but the allocation may not necessarily be socially desirable. References Baumgartner, S. (2000).Ambivalent Joint Production and the Natural Environment: An Economic and Thermodynamic Analysis. Hiedelberg. Physica-Verlag HD. Cowen, T. (1991).Public Goods and Market Failures. New Jersey. Transaction Publishers. Ferguson, C. (2004). The Broadband Problem: Anatomy of a Market Failure and a Policy Dilemma. Brookings. Brookings Institution Press. Estrin, S. Laidler, D. and Dietrch, M. (2008). Microeconomics 5th Edition. US. Prentice Hall Gordon, R. (2008). Macroeconomics 11th edition. US. Addison Wesley. Hens, T. and Reiger, M. (2010). Financial Economics: A Concise Introduction to Classical and Behavioral Finance. US. Springer. Keunne, R. (2000). Readings in Social Welfare: Theory and Policy. US. Wiley- Blackwell, pp 48-72. Lipsey, R. and Harbury, C. (1992). First Principles of Economics. Oxford. Oxford University Press. Mankiw, N.G. (2003). Macroeconomics 5th edition. US. Worth Publishers.  Stiglitz, J. (1991). The Invisible Hand and Modern Welfare Economics. US.NBER Working Paper No. W3641. Read More