MACROECONOMIC MANAGEMENT AND POLICY

Macroeconomic Management and Policy

Macroeconomic Management and Policy

Discuss the argument that competitive economies are efficient and explain why public goods, externalities, natural monopolies, and asymmetric information are market failures.

A perfectly competitive economy is allocatively efficient because it produces where price, which measures the value consumers place on the last unit produced, equals marginal cost, which measures the value to consumers that the resources used to produce the marginal unit could produce in other uses. Market failure occurs when freely functioning markets, operating without government intervention, fail to deliver an efficient or optimal allocation of resources. Therefore economic and social welfare may not be maximized which leads to a loss of economic efficiency. However, free markets can fail to achieve efficiency because of: (Medema 2004:15-20)

(1) Public Goods

The optimal quantity of a public good is provided when the marginal cost of production is equal to the sum of the prices that all its consumers will be willing to pay for the marginal unit produced.

This is difficult to attain because of the free rider problem - the incentive for individuals to understate the true value that they place on a public good.

(2) Externalities

The Coase theorem shows that if those parties that create an externality and those that are affected by it can bargain together with minimal transaction costs, all inefficiencies can be removed. (Djolov 2008:35-57)

Where private bargaining is impossible, the government can alleviate externalities by imposing rules and regulations or, more efficiently, by internalising externalities through such measures as taxes and tradable permits to pollute. Negative externalities cause marginal social cost to exceed price in competitive equilibrium.

Unregulated markets tend to produce excessive amounts of environmental damage. Zero environmental damage, however, is neither technologically possible nor economically efficient. Direct pollution controls are usually inefficient because, by mandating the same response from all agents, they do not minimize the cost of any given amount of pollution abatement. Efficient abatement requires that each firm have the same marginal cost of the last unit of abatement undertaken.

(3) Natural Monopolies

Government policy with respect to market power is designed to encourage competitive practices and discourage monopolistic ones. Direct control of pricing and entry conditions of some key oligopolistic industries has been common in the past, but deregulation is reducing such control. An important issue concerns the effect of market structure on economic growth.

The productively ineffective resource allocation that results whenever firms have market power may be more conductive to the technological change then is the productively efficient allocation that results from perfect competition.

In a competitive firm - price equals marginal cost while in the case of monopolized market price exceeds marginal cost. Monopolist charges a higher price therefore earning a higher profit. Also there is a deadweight loss implying that the monopolist produces less than the socially efficient quantity of output. (Friedman 1990:99-105)

Monopolist chooses to produce and sell the quantity of output at which the marginal revenue and marginal cost curve intersect; while the social planner would choose the quantity at which the demanded ...