MARKET EFFICIENCY AND MARKET FALURE

This chapter introduced the basic tools of welfare economics consumer and producer surplus and used them to evaluate the efficiency of free markets. We showed that the forces of supply and demand allocate resources efficiency. That is even though each buyer and seller in a market is concerned only about his or her own welfare they are together led by an invisible hand to an equilibrium that maximizes the total benefits to buyers and sellers.

A word of warning is in order. To conclude that markets are efficient we made several assumptions about how markets work. When these assumptions do not hold our conclusion that the market equilibrium is efficient may no longer be true. As we close this chapter let,s consider briefly two of the most important of these assumptions.

First our analysis assumed that markets are perfectly competitive. In the world however competition is sometimes far perfect. In some markets a single buyer or seller (or a small group of them) may be able to control market prices. This ability to influence prices is called market power. Market power can cause markets to be inefficient because it keeps the price and quantity away from the equilibrium of supply and demand.

Second our analysis assumed that the outcome in a market matters only to the buyers and sellers in the market. Yet in the world the decisions of buyers and sellers sometimes affect people who are not participants in the market at all. Pollution is the classic example of a market outcome that affects people not in the market. Such side effects called externalities cause welfare in a market to depend on more than just the value to the buyers and the cost to the sellers. Because buyers and sellers do not take these side effects into account when deciding how much to consume and produce the equilibrium in a market can be inefficient from the standpoint of society as a whole.

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