Principle 6: Markets work well with competition, the rule of law, information, property rights, and incentives
Standards:
12.2 Students analyze the elements of America’s market economy in a global setting:
Section 3. Explain the roles of property rights, competition, and profit in a market economy.
Objectives
Use the marginal principle to define and explain allocative efficiency
Identify conditions that prevent markets from acting efficiently
Identify issues that markets don’t address
Why you want to know this
This summary is a disclaimer. What we have been describing so far is a perfectly competitive market. There aren’t many of those. Here we will describe some of the qualifications that keep markets from Allocative achieving many of the economic goals that we have discussed earlier.
Allocative Efficiency
Markets do some things extremely well but they can’t even address other very important issues. In evaluating the market system, people should investigate both the advantages and the disadvantages. One of the advantages of markets is that they bring buyers and sellers together for their mutual advantage.
In addition, they allocate the proper amount of resources to different goods and services, providing exactly the amount of each product the buyers are willing and able to purchase given the opportunity costs of those choices. This result of competitive markets is called allocative efficiency and it takes a bit of explanation.
Recall the marginal principle -- all activities should be pursued as long as the marginal benefit of the activity is greater than the marginal opportunity cost. This principle holds with personal consumption issues, with production issues, and with societal resource allocation issues. The marginal principle can address the question, “From society’s perspective, what is the proper amount of resources to allocate to environmental purity, health care, education, or the production of steel, computers, automobiles, or any other good or service, given that each decision has an opportunity cost?” The answer to each question is that all activities should be pursued until the marginal opportunity cost of the activity outweighs the marginal benefit.
As will be seen, the farther away from the required conditions for an efficient market, the farther away the market gets from allocative efficiency. Those five conditions (CRIPI) insure allocative efficiency; their absence insures allocative inefficiency. Below, we will see some key reasons why markets can be inefficient, in other words, too much or too little of a good or service is produced. These inefficiencies occur when markets lack competition or information, when there is no rule of law, when property rights are ill-defined or unenforced, or when third party costs or third party benefits exist. In addition, we will see that markets may not work efficiently if discrimination exists, and that anti-poverty poverty programs face difficult challenges.
Lack of Competition
A perfectly competitive market (so many buyers and sellers that no individual can influence the price) will reach allocative efficiency automatically. But most markets are not perfectly competitive. When monopolists exist (single sellers of a product) and other less competitive firms have enough market power, they will maximize their profits by producing an output that is below that of allocative efficiency. Resources are under allocated to these products. In these cases, there is a conflict between the monopolist’s goal of profit maximization and society’s goal of allocative efficiency.
Absence of the Rule of Law and incentives.
In many nations, people in government are not held to the same laws as the general population. In fact, some would claim that these governments are “kleptocracies,” governments of thieves. In these nations, people are uncertain about the “rules of the game” that change often, so planning is impossible and incentives to produce efficiently, save and invest are absent.
Lack of Information Asymmetric information exists if either the demander or the supplier has greater information than the other. Health care exemplifies the problem of asymmetric information. The health care provider has much greater information about medicine and the body than does the patient. In an emergency situation, a patient might not even be conscious when she “buys” medical care. In cases like these, markets are not likely to reach allocative efficiency. It is difficult to measure the marginal utility that a patient might receive from different quantities and types of health care. As a result, a true equilibrium price is difficult to find. Other examples are automotive repairs, financial services, electronic products, and houses, where it is “costly” to acquire information so the buyer goes into the transaction with less information than the seller or hires a “middleman/woman” who has invested her human capital in acquiring the information. The Internet and advertising, however, help to provide information at low cost to the buyer.
Ill-defined or Unenforced Property Rights
Property rights are key in achieving allocative efficiency. Pollution, for example, exists because it is difficult to assign property rights to the air, the rivers, the oceans, and other “dumping grounds.” Since no one owns the air, no one can charge for using it. Since no one charges for using it, people have little compunction dumping their exhaust fumes, waste particulates, and other noxious items into it. If the price of a product is zero, people will overuse it. Unless there is a way to assign a price to these activities, people will continue to overuse the environment as a dumping ground.
External benefits and costs
Huy Fong, the company that produces Sriracha, one of the most popular hot sauces on the market,
“was hit with a lawsuit last fall after residents near the Irwindale, Calif. factory complained of eye and throat irritation and headaches from the facility’s chili pepper odor. In November, a Los Angeles judge ordered a “partial shutdown“ of the factory on the grounds that the odor is “extremely annoying, irritating and offensive to the senses warranting consideration as a public nuisance.” And in December, Huy Fong was ordered to hold its sauces for 30 days before shipping.”….Huffington Post, April 18, 2014
Huy Fong made a choice – to produce a product and give up sweet smelling air. However, the cost of that choice was imposed on all of the people in the neighborhood. They were bearing the cost of Huy Fong’s choice. Because the property rights to the air through which the odor traveled were not defined, Huy Fong was able to avoid paying the neighbors for the cost of the choice to produce the smelly product. The cost of Huy Fong’s choice was imposed on the neighbors; it is an external cost. An external cost is the cost of a choice made by one group or individual but borne by another group or individual. People who were neither consumers nor producers of the sauce (i.e., third parties) were paying part of the cost of barbecue production. Huy Fong was not paying that cost so they did not include it in their calculations as a production cost. The private supply price was less than the true supply price, because it did not include an air filter system that would reduce the odor. As a result, Huy Fong’s estimation of costs is less than the true costs to his customers plus the cost to the neighbors.
When third party costs exist and are not included in the supplier’s estimation of costs, costs will be underestimated. To the extent that those costs determine the supply schedule of the firm, costs will be too low, so supply will be too great. Where third party costs exist, resources will be over-allocated to the activity. Obviously, allocative efficiency will not occur; society will allocate too many resources to that activity.
External or Third Party Benefits A roommate downloads some music that everyone enjoys. A neighbor hires a gardener who beautifies the front yard. Everyone in the neighborhood enjoys it and property values rise. People are vaccinated against contagious diseases, reducing the threat to everyone else. Measures are taken that reduce drunk driving, reducing the number of automobile casualties. People become educated which increases the productivity of the labor force, reducing costs and prices for all consumers.
All of the above are examples of third party or external benefits. The benefits to the individual consumer of the good or service are less than the total benefits to society since others also benefit. In these cases, private demand for the product underestimates the utility (pleasure) received from different quantities of the product. The full benefits to society (the sum of private and external benefits) exceed the private benefits received by the producer of the positive externality. Where third party benefits exist, resources will be under-allocated to the activity. The benefit from consuming the product is underestimated so the market produces too little of the product. Obviously, allocative efficiency will not occur; society will allocate too few resources to that activity.
Two other conditions exist that prevent allocative efficiency.
Poverty
Different resource endowments, together with other factors such as discrimination, mean that income is not equally distributed among households, with some earning so little that they can meet few of their economic wants. Social goals other than efficiency may dictate that a society find ways to assist people with very low incomes
To the extent that some people have insufficient education, some are physically disabled, some are unemployed, some are young, some are old, the market does not allocate sufficient goods and services for many to escape poverty. Markets are not capable of addressing the initial endowment of resources or the inability of some people to participate in labor markets and the denial of access to markets that may result from illegal discrimination.
Who is poor in the U.S.?
Anti-poverty policies often become mired in endless debates about the “deserving poor” and often involve discussions bordering on racism and sexism. The fact is that those living in poverty fall into many different categories. The following data are from, the Brookings Institute, generally considered to be somewhat liberal. The original data come from The Current Population Survey (CPS), sponsored jointly by the U.S. Census Bureau and the U.S. Bureau of Labor Statistics (BLS).
Category | % of Total |
Children under 18 | 33% |
In the labor force | 24% |
Disabled | 12% |
Seniors | 11% |
Caregivers | 8% |
Students | 7% |
Early retirees | 3% |
Unclassified | 2% |
Total | 100% |
As you can see from the table in 2016, 64% of the poor are either children, disabled people, seniors, caregivers or people working or seeking work. Devising policies to “put the poor to work” clearly misses the mark for most of the people in these categories. The goal of an anti-poverty program is to develop policies that do not provide disincentives to work while at the same time take into consideration particular characteristics of much of the poverty population. These characteristics must be considered in facing the tradeoff between incentives and efficacy (getting the job done). These are difficult issues and are often buried in the rhetoric and the politics of “welfare” policies.
Discrimination Webster defines discrimination as the act of distinguishing differences. Most would agree that there is no harm in distinguishing differences. In fact, society does this all the time. The National Basketball Association discriminates in favor of tall people with particular skills. Colleges and Universities discriminate in favor of people with strong high school academic records. Employers discriminate in favor of people who appear to have the human capital that matches the job requirements. In fact, as a result of scarcity, economies must use some form of discrimination in allocative decisions. That discrimination usually takes the form of allocating products to those with the ability to pay.
A further definition of discrimination, however, is “a showing of partiality or prejudice in treatment; specific action or policies directed against the welfare of minority groups.” It is discrimination based on characteristics that have nothing to do with the issue at hand, which appears to be irrational. When suppliers refuse to sell to some people they are reducing sales and income. When demanders in a labor market refuse to hire the most qualified worker due to racial, ethnic, gender or other personal characteristics, they are reducing potential profits. Economics adds another argument to the case against discrimination; discrimination prevents society from making the best use of all of its resources. While market incentives provide reasons to avoid discrimination, they can’t override the utility that some derive from practicing discrimination. In markets where competition exists, there are strong incentives to avoid costly discrimination, since those that do not discriminate will drive the discriminators out of the market.
Bottom Line
Markets effectively allocate resources when the CRIPI factors are present. If those factors are not present, if external costs or benefits exist, or if people discriminate, the market will not achieve allocative efficiency. The market cannot address poverty.
Markets effectively allocate resources when the CRIPI factors are present. If those factors are not present, if external costs or benefits exist, or if people discriminate, the market will not achieve allocative efficiency. The market cannot address poverty.
1. For a society, what type of efficiency involves devoting resources to production of a good or service up to the point where the marginal benefit from consuming the product is just equal to the marginal cost of consuming the product?
a. Technical
b. Allocative
c. Marginal
d. Distributive
2. Which of the following would be an example of an external cost?
a. Your roommate chooses to download some awesome music.
b. Your football team chooses to put in the hard work to post a winning record and your friends from other schools congratulate you. You hate football and didn’t go to a game all season.
c. You are a teacher. A student chooses to miss an exam to travel out of town to attend his Grandma’s funeral. (This is the third Grandma’s death in ten weeks???) He wants to take a makeup exam. You will have to use your human capital to write a new exam.
d. You are a teacher and you choose not to use your human capital to prepare your students for a statewide exam. They all flunk and you are fired.
3. Which of the following is an example of an external benefit?
a. Your football team chooses to put in the hard work to post a winning record and your friends from other schools congratulate you. You hate football and didn’t go to a game all season
b. You choose to use your human capital to study hard for an exam and you get a great grade.
c. Your teacher chooses to work hard to prepare your class for an exam and you get a great grade without even studying. Your parents choose to use their human capital to earn enough for you to go to an expensive summer camp which you have always wanted to attend.
d. All of the above are external benefits.
4. In 2016, what percentage of the poor were under the age of 18?
a. 33%
b. 25%
c. 21%
d. 18%