State and market
Anonymous . The Economist ; London Vol.338,Iss.7953, (Feb 17, 1996): 64-65.
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ABSTRACT (ABSTRACT)
The final article in a series on economic fallacies argues for a strong presumption in favor of markets in instances
of “market failure.” This presumption stems not from the idea that markets work perfectly, because they never do,
but from the fact that the alternative is usually worse.
ABSTRACT
Market failure is pervasive and comes in 4 main varieties: 1. monopoly, 2. public goods, 3. externalities, and 4. lack
of information. More than critics allow, however, markets find ways to mitigate the harm – and that is a task at
which governments have often been strikingly unsuccessful.
FULL TEXT
Headnote
People are quick to assume that “market failure” justifies action by the government. This final brief in our series on
economic fallacies argues for a strong presumption in favour of markets-not because they always work perfectly
(they never do) but because the alternative is usually worse
ACCORDING to the central deduction of economic theory, under certain conditions markets allocate resources
efficiently. “Efficiency” has a special meaning in this context. The theory says that markets will produce an
outcome such that, given the economy’s scarce resources, it is impossible to make anybody better-off without
making somebody else worse-of Economic theory, in other words, offers a proof of Adam Smith’s big idea. In a
market economy, if certain conditions are met, an invisible hand guides countless apparently uncoordinated
individuals to a result that is, in one plausible sense, the best that can be done.
In rich countries, markets are too familiar to attract attention. Yet a certain awe is appropriate. When Soviet
planners visited a vegetable market in London during the early days of perestroika, they were impressed to find no
queues, shortages, or mountains of spoiled and unwanted vegetables. They took their hosts aside and said: “We
understand, you have to say it’s all done by supply and demand. But can’t you tell us what’s really going on? Where
are your planners, and what are their methods?”
The essence of the market mechanism is indeed captured by the supply-and-demand diagram shown in chart 1.
The supply curve measures the cost to sellers, at any level of output, of selling one more unit of their good. As
output grows, the law of diminishing returns forces this extra (or marginal) cost higher, so the supply curve slopes
upwards.
In the same way, the demand curve measures the benefit to consumers of consuming one more unit. As
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consumption grows, the benefit from extra consumption falls, so the demand curve slopes downwards. At the
place where the curves cross, a price is set such that demand equals supply. There, and only there, the benefit
from consuming one more unit exactly matches the cost of producing it.
if output were less, the benefit from consuming more would exceed the cost of producing it. If output were higher,
the cost of producing the extra units would exceed the extra benefits. So the point where supply equals demand is
“efficient”.
The shaded area in chart 2 shows the “surplus” created by the market. The upper part is the consumers’ surplus:
the benefit from consumption (ie, the total area under the demand curve) less what consumers have to pay for it In
the same way, the lower part measures the producers’ surplus: revenues received, less the cost of production (the
area under the supply curve).
This gain in welfare is at its greatest if consumption and production happen where the lines cross. If, for some
reason, consumption and production are less than that, the surplus is smaller and the economy suffers what
economists call a deadweight loss, as shown in chart 3.
If production and consumption are more than the efficient amount, the same is true. Producers’ surplus is smaller
because the extra output has cost more to make than it brings in revenues; consumers’ surplus is reduced
because the extra consumption has cost buyers more than the benefits it brings. Again, as shown in chart 4, the
economy suffers a deadweight loss.
Fine on paper
