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Market Inefficiency

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Market Inefficiency

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.

Market Inefficiency Meaning

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. The Forms of Market Inefficiency There are three main forms of market inefficiency. These are allocative, productive, and informational inefficiency. 1. Allocative inefficiency - Here, the marginal cost of a product does not equal its price. 2. Productive inefficiency - Consider two products that can be produced at a quantity of 10 each. However, when the quantity of one is increased to 11, only 8 of the other product can be produced. If 11 of one product is made, this results in productive inefficiency. 3. Informational inefficiency - Here, one side of the market (either the demand or supply side) has more information than the other. For instance, if a seller sells a$5 product for $6 to an unsuspecting customer, this is informational inefficiency as the benefit to the customer has not been maximized. Market Inefficiency Diagram 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 Market Inefficiency Monopoly 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 Causes of Market Inefficiency 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. 1. Positive and negative externalities - An externality is the effect of producing or consuming a given good that is felt by a third party. The positive ones affect others positively whereas the negative ones affect others negatively. For example, as a car owner buys and drives a car, the emissions pollute the environment for everybody else, and this is a negative externality. However, as a student receives an education and becomes a doctor, this student provides healthcare for the community, making it a positive externality. 2. Free riding - This involves the use of public resources by others who did not contribute to its provision. Here, there is little incentive for public goods to be produced since everybody wants to wait for others to produce them. 3. Monopoly - Here, only one seller of a good without a substitute controls prices by increasing them to a point where consumers buy less and less. In the end, the producer produces below optimal levels and the consumers buy below optimal levels. 4. Information asymmetry - This happens when one side of the market has more information than the other side. For instance, if a seller knows a sealed box labeled 1 pound contains less than 1 pound but sells it for the price of 1 pound, the consumer surplus is less than it should be, creating a market inefficiency. 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. Market Inefficiency Examples 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 - Key Takeaways • 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. 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. • An externality is the effect of producing or consuming a good that is felt by a third party. • There are three main forms of market inefficiency. These are allocative, productive, and informational inefficiency. • 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. Frequently Asked Questions about Market 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. 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. Final Market Inefficiency Quiz Question What is market inefficiency Show answer Answer 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. Show question Question The optimal outcome is the outcome in which the benefits do not match the cost. Show answer Answer False Show question Question 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. Show answer Answer True Show question Question The total economic surplus is not maximized when the benefits fully account for the costs. Show answer Answer False Show question Question What is an externality? Show answer Answer An externality is the effect of producing or consuming a good that is felt by a third party. Show question Question Social efficiency refers to a situation where the internal and external costs are not equal to the internal and external benefits. Show answer Answer False Show question Question What is deadweight loss? Show answer Answer 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. Show question Question What is a monopoly? Show answer Answer A monopoly is a market in which a single producer has absolute control over a good with no substitute and is the only seller. Show question Question What are the forms of market inefficiency? Show answer Answer Allocative, productive, and informational inefficiency. Show question Question What is allocative inefficiency? Show answer Answer The marginal cost of a product does not equal its price. Show question Question A positive externality means society is harmed indirectly. Show answer Answer False Show question Question A monopoly is an inefficient market. Show answer Answer True Show question Question What is the consumer surplus? Show answer Answer It is the benefit of the consumer. Show question Question What is the producer surplus? Show answer Answer It is the benefit of the producer. Show question Question What is the total surplus? Show answer Answer It is the benefit of both the producer and consumer combined. Show question Question Select the wrong statement. Show answer Answer The optimal outcome is the outcome in which the benefits match the cost. Show question Question 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.

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Question

Which of the following is not a main form of market inefficiency?

allocative inefficiency

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Question

As a car owner buys and drives a car, the emissions pollute the environment for everybody else, and this is a ...

negative externality

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Question

... involves the use of public resources by others who did not contribute to its provision. Here, there is little incentive for public goods to be produced since everybody wants to wait for others to produce them.

Free riding

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Question

Fill the blanks:

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 will ...

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 .., and the consumer surplus will ... as the seller sells hats at a high price.

rise/monopoly/decrease

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Question

... happens when one side of the market has more information than the other side.

Information asymmetry

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Question

Explain the information asymmetry.

It happens when one side of the market has more information than the other side. For instance, if a seller knows a sealed box labeled 1 pound contains less than 1 pound but sells it for the price of 1 pound, the consumer surplus is less than it should be, creating a market inefficiency.

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Question

Fill the blank:

In a ..., only one seller of a good without a substitute controls prices by increasing them to a point where consumers buy less and less. In the end, the producer produces below optimal levels and the consumers buy below optimal levels.

Monopoly

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Question

Explain the free riding problem.

This involves the use of public resources by others who did not contribute to its provision. Here, there is little incentive for public goods to be produced since everybody wants to wait for others to produce them.

Show question

Question

Fill the blank:

There are three main forms of market inefficiency. These are allocative, ... and informational inefficiency.

productive

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Question

What does social efficiency mean?

Social efficiency refers to a situation where the internal and external costs are equal to the internal and external benefits.

Show question

Question

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 ... that is not being considered by the company.

indirect cost

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Question

When is the total economic surplus maximized?

The total economic surplus is maximized when the benefits fully account for the costs.

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Question

What is the optimal quantity of a product?

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.

Show question

Question

Fill the blank:

An ... is the effect of producing or consuming a good that is felt by a ... party.

externality/third

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