Originally written for Professor Westphal’s Microeconomics course at Swarthmore College in the fall of 1997.

____________

The economist who claims that the free market is the best way to allocate resources does not disagree with the economist who argues that such a market shows why it will fail at allocating these resources. Any economic system will somehow allocate resources: whether that economic system leaves the resources unused where they are or whether it permits one entity to consume all resources endlessly is another point entirely. In that sense the latter economist is hopelessly wrong, since it is impossible to “fail” to allocate resources. In order to give this paper some substance rather than semantics, I will focus my discussion on the issue of efficiency. I contend that free markets offer the most efficient allocation of resources because they reveal exactly why they are flawed at doing so.

Before discussing how a market economy approaches efficiency, the definition of efficiency must be clear. A resource allocation is efficient if there is no other alternative resource allocation that would make one party better off without making the another party worse off. This definition can be subdivided into three segments. In the simplified microeconomic world, there are only producers and consumers, so we must investigate the efficiency of resource allocation between all producers, between all consumers, and between producers and consumers.

The efficiency of resource allocation between producers, or the “efficiency in production” is stated by the requirement that the marginal rates of substitution (MRS) between production inputs must be the same for all firms. Figure 1, an Edgeworth box plotting the labor and capital distribution between two firms A and B shall be used to describe this. Any point in the box is a feasible allocation of resources, but we are interested in only those allocations on the Production Contract Curve because only along this curve are MRS’s equal for both firms. This equality is represented by the tangency of their isoquants, curves which show all the possible combinations of labor and capital that will achieve a given level of output. Examples of these curves are Isoquant A and Isoquant B in Figure 1. Quantity of output from Firm A (Qa) is Qa1 along Isoquant A. Quantity of output from Firm B (Qb) is Qb1 along Isoquant B. If the MRS’s were unequal, i.e., if the resource allocation did not lie on the Production Contract Curve, then it would be possible to reallocate resources such that one firm does not lose any of its production and the other firm gains production capability which, by definition, is not efficient.

Now let us consider the efficiency of resource allocation between consumers, or the “efficiency in consumption.” This aspect of efficiency is represented by the requirement that the MRS between goods bought by a consumer equals the MRS between goods bought by other consumers. This equality can also be represented by an Edgeworth box, as shown in Figure 3. Let us continue to consider labor-capital allocation from Figure 1 at which Qb = Qb1 and Qa = Qa1. With these outputs given, we can now allocate them between the consumers. Again, any allocation is possible, but only a certain set of these allocations, in this case those on the Consumer Contract Curve, are efficient. Along this curve the indifference curves (IC’s) of the consumers, which represent all the combinations of the goods produced by Firm A and B that would yield a given level of utility, are tangent. The example IC’s in Figure 3 are ICX for Consumer X, which yields a utility level of Ux1, and ICY for Consumer Y, which yields a utility level of Uy1. The logic behind this is exactly the same as that for the producers: if the MRS’s were not equal, it would be possible to trade such that one consumer gains in utility without sacrificing the utility of the other. Such a resource allocation is, once again, by our original definition, inefficient.

Finally, we must investigate the efficiency in the resource allocation between the producers’ output and the consumers’ levels of consumption, or the “efficiency in output mix.” This condition is that the marginal rate of transformation (MRT) of the goods produced equals the MRS of the consumers. This equality can be seen in Figure 2, which links Figures 1 and 3. The Producer Contract Curve (Fig. 1) mapped into output space (Fig. 2) gives us the Production Possibility Frontier (PPF). Note also that the Edgeworth box in Figure 3 can be inscribed into Figure 2 by dropping perpendiculars to the axes at Qa1 and Qb1. The slope of the PPF at this point is the MRT, representing the amount of one good that could not be produced were another unit of the other good to be produced instead. If this ratio does not equal the MRS of the consumers, as shown by the MRT in Figure 4, then there is a shortage of one good for one consumer and a surplus of the other good. In Figure 4, Consumer X begins on the contract curve. The MRT compels him to trade some B for A, because that would place him on the higher indifference curve ICX2. Unfortunately, not being on the contract curve is inefficient, because Consumer Y could be made better off without costing Consumer X anything by merely reallocating resources.

All of this analysis leads to a dramatic conclusion. Just as the Production Contract Curve created the PPF, so too does each Consumer Contract Curve map a set of points into utility space, as shown in Figure 5. Let us say, for example, that the Consumer Contract Curve in Figure 3 gives us the Utility Possibility Curve UPC-i in Figure 5. Remember, however, that we derived the Consumer Contract Curve with the assumption that Qa = Qa1 and Qb = Qb1. For every output allocation there is a different Consumer Contract Curve, and each of these curves maps a new UPC in utility space, exemplified in Figure 5 by two additional lightly drawn curves. The actual Utility Possibility Frontier (UPF) takes one point from each of these UPC curves, where MRS = MRT, and is essentially the envelope of all these curves, represented in bold in Figure 5. The final step is to take this information about utility and consumer preferences and construct Community Indifference Curves in output space, as represented in Figure 6. Note that only one indifference curve achieves a point of tangency with the PPF, and this is the ultimate ideal production level, yielding Qa* and Qb*.

Now that we know what efficiency entails, how do we achieve it? What the free market approach provides is an ideal to strive for, an ideal that will naturally achieve the efficient allocation of resources: perfect competition. Those who claim that the market system fails argue correctly that the perfectly competitive market is extremely rare. It is this point, however, that allows the free market to work, because by establishing the ideal goal, it is easy to see how reality differs from that goal and what is necessary to make economics work to attain it. Free market pessimists provide four major aspects of the real market system that hinder the achievement of absolute efficiency: market power, incomplete information, externalities, and public goods. Of course, the market system is unable to address these problems alone. The remainder of this paper will discuss these problems and how careful government intervention can aid the market in coming closer to the efficient outcome described above.

  1. Monopolies: First, market power creates inefficiencies because the monopoly does not produce enough of the product that society wants. (A monopsony could be used instead of monopoly just as easily.) Therefore resources have been freed up for other firms to use, leading to over-production in other areas of the economy. Although it is possible for all the firms to be operating efficiently in and of themselves, the misallocation of resources amongst the firms would shift society’s point of production along the PPF away from the equilibrium, such as to where the PPF intersects IC1 in Figure 6. There is no way the market can alleviate this problem on its own. The best way to do so is for the government to intervene with anti-trust laws, but these cost money to administer, and sometimes it is difficult to tell what is a monopoly and what is not. Even more complex is the widespread existence of monopolistic competition, which, in addition to having some of the inefficient price-setting power of a monopoly, also incurs societal loss through excess capacity.
  2. Incomplete Information: The second source of inefficiency is incomplete information. At the extreme, incomplete information drives high-quality goods out of the market. This is inefficient because, just as with monopoly, too much of one product and too little of another is produced, driving society along the PPF away from the ideal equilibrium. Although the onset of the “information age” and computer technology makes this issue seem like it is much less of a problem, it still inevitably exists, and the market itself cannot whisk it away. Some private approaches have worked well in providing information about products or services, such as extending product warranties or developing reputations for goods and services, but the infinite awareness of all information required by perfect competition can never be achieved.
  3. Externalities: The third source of inefficiency comes from externalities, which are unintended side effects of market transactions that are not taken into account by the market itself. Thus, producers may not produce or consumers may not consume the efficient amount of products. Fortunately, as the Coase Theorem states, most of these issues can be resolved if the externalities are properly worked into the property rights system and if there are no transaction costs. For example, if polluters were given permits to pollute (i.e., property rights) they could buy and sell them, essentially creating the market for pollution that is needed to achieve the efficient outcome. If transaction costs are high but the government has accurate information, it can assess damages or levy taxes that would achieve the efficient solution. In the case that transaction costs are high and information about the damages is limited, externalities become an inefficiency about which there is very little to be done.
  4. Public Goods: Finally, public goods are another source of inefficiencies. The consumer of a public good does not even realize that the good is scarce and acts as if there is an unlimited supply of it. For example, if everyone were completely insured, such that medical care was a public good, then individuals would have no incentive to take preventative action. Thus, public goods are consumed at an inefficiently high level, again moving society away from the ideal equilibrium on the PPF. The government is the only institution that has any hope of administering public goods, but, just as with externalities, if the information on consumer demand is not readily available, then assessing the proper amount to produce is very difficult.

Thus, the cost of anti-trust laws, the impossibility of alleviating the inefficiency of monopolistic competition, the absence of infinite information, and the existence of transaction costs all hinder even the government-aided market economy from achieving absolute efficiency. However, the beauty of the market system is that does much of the work towards efficiency on its own. The free market system is the best way to allocate resources because no other system gives us so much information or gets us so close to the efficient outcome with so little effort. At the same time, the free market does indeed fail, but, by establishing an ideal of perfect competition, it is able to show us exactly how it failed and what the government needs to do to bring the economy closer to absolute efficiency.

Advertisement