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Wouldn't it be lovely if that cup of coffee was sold for exactly how much it cost to make it? Now, wouldn't it be lovely if you were paid a salary that is directly equal to the value of the product you made for the company? If your answer is yes, then you would be helping create an efficient market. This is because for market inefficiency to occur, you would have to take a salary that exceeds the value of the work you did. Continue reading for an interesting discussion on market inefficiency.
What is the meaning of market inefficiency? To explain this properly, let's first tell you what an efficient market is. In an efficient market, economic agents are getting as much benefit as possible from their limited resources. In other terms, their costs are matching their benefits perfectly. An inefficient market is the direct opposite of this. Market inefficiency refers to a situation where markets are unable to achieve the optimal outcome and the transactions are not mutually beneficial.
Market inefficiency refers to a situation where the transactions in a market are not mutually beneficial and the market fails to achieve the optimal outcome.
The optimal outcome is the outcome in which the benefits match the cost. For a product, the optimal quantity is the quantity where the marginal benefit of consuming one more unit is equal to the marginal cost of producing that unit. When this happens, the total economic surplus has been maximized!
The optimal outcome is the outcome in which the benefits match the cost.
The optimal quantity of a product is the quantity where the marginal benefit of consuming one more unit is equal to the marginal cost of producing that unit.
The total economic surplus is maximized when the benefits fully account for the costs.
Market efficiency is achieved in a perfectly competitive market when equilibrium is reached. Here, the equilibrium quantity of the market is equal to the socially optimal quantity only when the costs and benefits are internalized by economic agents. What does all this mean? Let's break it all down.
An externality occurs when an economic agent only looks at the direct costs and benefits of a decision without considering the indirect costs and benefits (Look at Figure 1). Look at the following example.
Figure 1. Market inefficiency: externalities - StudySmarter
An externality is the effect of producing or consuming a good that is felt by a third party.
A coal mining company uses a method that costs $5 to mine coal. This method of mining coal produces 1 bag of coal but pollutes one gallon of air for the whole community, which includes those who neither produce nor consume the coal.
In the example, air pollution is an indirect cost that is not being considered by the company. To account for air pollution, the company has to use an alternative method that costs $10 with no air pollution. If the company does this, it has internalized the costs. In other words, the whole community is not paying some of the costs resulting from the polluted air as with the $5 method.
This is how social efficiency is achieved. It is achieved when all the internal and external costs and benefits have been accounted for.
Social efficiency refers to a situation where the internal and external costs are equal to the internal and external benefits.
Social efficiency can also be described as the optimal distribution of resources.
There are three main forms of market inefficiency. These are allocative, productive, and informational inefficiency.
Market inefficiency refers to a situation where the transactions in a market are not mutually beneficial and the market fails to achieve the optimal outcome. When this happens, there is deadweight loss, which refers to the loss of total surplus as the marginal costs do not equal the marginal benefits. Figure 2 shows the market inefficiency diagram.
Deadweight loss refers to the loss of total surplus, or consumer and producer benefits, as the marginal costs do not equal the marginal benefits in an inefficient market.
Figure 2. Market Inefficiency in a Perfectly Competitive Market, StudySmarter Originals
Unlike perfect competition, a monopoly does not lead to mutually beneficial outcomes for both suppliers and consumers. This is because in a monopoly, a firm can focus only on the private benefits without taking externalities into consideration. Here, the firm can raise the price of its product to a point where its surplus exceeds the consumer surplus. When this happens, economists say that the firm is exercising market power. However, in perfect competition, both the consumers and producers play a part in determining the prices. Look at the following example.
In a town, there are 100 sellers of hats. The buyers of these hats will only buy the hats at the lowest price offered. The hat sellers, wanting to sell their hats quickly, will lower the prices of their hats, and consumer surplus (the benefit of the consumer) will rise.
In the same town, imagine there is only one seller of hats. The buyers have no choice but to buy from this one seller. This represents a monopoly, and the consumer surplus will decrease as the seller sells hats at a high price.
A monopoly is a market in which a single producer has absolute control over a good with no substitute and is the only seller.
Figure 3 shows market inefficiency in a monopoly.
Figure 3. Monopoly Market Inefficiency, StudySmarter Originals
Market inefficiency occurs in imperfectly competitive markets, but what are some of the underlying causes of market inefficiency? Let's list and explain some of them.
This list covers the fundamentals and is not exhaustive of all possible causes. Once you access a market relationship and realize there is a mismatch between cost and benefit, there is a market inefficiency.
There are many real-world market inefficiency examples. Some of these are Microsoft (Windows), Apple Inc. (IOS), and utility firms among others. All these entities provide products with no direct substitutes, which gives them a great deal of control in the market.
Market inefficiency refers to a situation where the transactions in a market are not mutually beneficial and the market fails to achieve the optimal outcome.
Market inefficiencies are identified by situations where the benefits don't equal the costs or the optimal outcome has not been achieved.
The 3 forms of market inefficiency are allocative, productive, and informational inefficiency.
Examples of market inefficiency include Microsoft (Windows), Apple Inc. (IOS), and utility firms.
Causes of market inefficiency include positive and negative externalities, free riding, monopoly, and information asymmetry.
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