ExplainedByED: when the market fails us

Markets rarely obey economic theories. |n fact most of the time it can feel as if markets are a 4-year-old child deliberately defying their parents. Economists call this deviation from Pareto efficiency — a situation where a reallocation of resources to make one party better off cannot be executed without making another worse off — market failure. Debatably encountered in every market due to the abundance of factors which have the ability to breach the criteria of the Economic utopia that is Pareto efficiency, the perfectly competitive market model (displayed below) acts as a starting line from which appropriate adjustments can be applied to reflect a more realistic market scenario.

The left hand graph is a simple supply and demand diagram. A market equilibrium is achieved where the demand in an industry for what a particular industry provides, be it a specific good or service, equals the supply. Try and follow the linesof demand and supply and relate them to the axis: as the price increases, the demand decreases yet the supply increases. This makes sense as consumers will buy a higher quantity at a lower price, yet suppliers will provide more to the market at a higher price in pursuit of profit. At the intersection point, exactly what is supplied by the firms is purchased by consumers at the agreed price denoted by ‘P’ on the y axis. This is the only price with the current accounted for market conditions in which supply will equal demand.

The right hand graph represents the demand and cost functions of a firm within this market. At price ‘P’ determined by the forces of supply and demand, any individual firm in the industry will have a horizontal demand curve, as shown. This is because firms in a perfectly competitive market are price takers; they do not have any influence over the market equilibrium therefore they trade at the market price ‘P’. This type of demand curve is called ‘perfectly elastic’ and indicates regardless of quantity supplied, the firm will always provide to the market at price ‘P’.

If you read my last post, the fact the demand, marginal revenue and average revenue all lie on the same horizontal line may confuse you. Stick with me. Remember, the price traded is always the same for a firm in perfect competition, therefore the profit gained from selling each additional unit will remain constant, thus creating a horizontal marginal revenue curve. Average revenue is total revenue divided by quantity and because all the units are the same price, every unit will have the same average revenue, replicating the horizontal line of marginal revenue and demand. Once you piece together the different segments of the individual firm’s graph, it’s actually satisfyingly simple. The last component is the average costs curve. The firm will provide the quantity to the market which correlates to the tangency of the average cost curve and the demand/marginal revenue/average revenue curves as shown once again in the diagram (note this is also the point where marginal costs intersect the other two curves, with the reasoning for this clarified in my previous post). This is the point where the firm’s revenue equals costs. A price below this would result in losses, and a price above this would result in nothing being sold as consumers would switch to buying from another firm in the industry who is selling at price ‘P’ as all firm’s goods in a perfectly competitive market are perfect substitutes, i.e. homogenous.

I’m conscious this is a lot if you’ve never delved into the world of economics, so here are the main takeaways:

• the market price is determined by the forces of supply and demand of the entire industry
• each firm in the industry has no singular influence over this price, and therefore trades at this agreed ‘P’ creating a horizontal demand curve
• at ‘P’, a firm’s average costs, marginal revenues and average revenues are all equal, therefore equalling the price
• this means a firm’s revenues = costs
• combining these facts satisfies the conditions of perfect competition (a market structure often highly contested) and subsequently Pareto efficiency

The concept of competitive markets leading to Pareto efficiency is the first theorem of welfare economics. When this assumption fails (an inevitable outcome, some would argue), inefficiencies occur. A type of inefficiency is an externality, the focus of this post. Externalities are a crucial aspect to microeconomics because they succeed in developing an aspect of reality often neglected in economic theory: the costs or benefits which affect parties or agents not involved in the economic activity being analysed. This means the impacts of the trade on third parties are not internalised in the market mechanisms or price determination. The consequences of this, which will be analysed in more detail in a moment, are a misallocation of resources, reducing allocative efficiency. This is because the complete total cost (known as the social costwhich is private cost + external cost) of the production or consumption is not accounted for. The types of externalities are displayed below, accompanied by some examples:

MPC = marginal private cost

MSC = marginal social cost

MPB = marginal private benefit

MSB = marginal social benefit

The two scenarios shown above are comprehensive hypothetical graphs displaying what happens to production when the entire costs are not included in the market mechanism. An easy way to understand what ‘lines’ (although in economics, regardless of how linear linear a function appears we call it a curve) adjust, think of benefit curves in relation to demand curves and therefore impacted by consumption, and the cost curves in relation to supply and therefore impacted by production.

A positive externality in consumption arises when the marginal social benefit is greater than the marginal private benefit. When making purchasing decisions, an individual only accounts for the private benefits, consequently consuming less than the social optimum. Q1 on the left hand diagram is the private optimum level of consumption yet the social optimum is Q2, therefore a positive externality in consumption leads to underconsumption. The shaded triangle (on all externality diagrams) represents the deadweight loss of social welfare, exemplifying the ‘error’ in allocation of resources by the market mechanism. The vertical distance between cost curves is the external cost. This completes the equation for social costs, derived by summing the private costs and external costs. Conversely a negative externality in consumption would occur when the MSB is less than the MPB (so on the diagram, the only difference would be these two curves would switch ‘places’), resulting in an overconsumption. For simplicity in both cases, I have kept the private and social cost equal however, this is an unrealistic market expectation.

The production scenario I chose to display is a negative externality in production. For simplicity once again, I have now equalised the private and social benefits. When a negative externality in production occurs, the marginal private cost is greater than the marginal social cost. As illustrated, this causes an overproduction of output because the socially optimum level of output is below that of the private optimum. As with consumption externalities, this leads to a misallocation of resources due to not taking the full impact on all economic agents into account, leading to a deadweight loss of social welfare. A positive externality in production would be reflected when the marginal social costs are greater than the marginal private costs, leading to an underproduction.

If you’re a perfectionist or have extreme attention to detail, there may be a wittering voice in your head going, “but why aren’t the social and private lines parallel?” Maybe there isn’t, but I’m going to answer you anyway. This returns back to the fundamentals of any marginal function discussed in my last post. The divergence of these curves (and remembering that they’re curves and not lines may help with this clarification) occurs because as output increases, the marginal (which to remind you is the added impact of increasing output, for simplicity we’ll say by a unit of one) costs or benefits in private and social scenarios become decreasingly aligned. This means that the greater the deviation from the social optimum, the more the deadweight loss of social welfare will progressively increase with just one unit increase of output.

There are copious examples where externalities can be applied and a solution subsequently proposed. Think of a factory which polluted the local air in production. This is a negative externality in production. The pollution impacts the trade of anearby farm, owned by a separate owner to that of the factory. This farm has no control over the levels of pollution, yet has to take into account the pollution in their cost functions. But if this factory and farm merged and were owned by the same individual, this individual would internalise the ‘cost’ of the pollution of the factory on the farm and internalise it to reach a socially optimum level of output for both the factory and farm. This would negate the externalities previously experienced and allow an equilibrium which internalises the third party impacts.

This seamlessly prepares you for a topic I’ll be writing on soon, called The Tragedy of the Commons. A ‘common’ is something a vast amount of people have access to and when one person is using it, there is no exclusion to another from using it too. It also includes goods not owned privately such as air and other natural resources, economically referred to as’free goods’. Common (see what I did there) examples are fishing, fast fashion, coffee, etc. The key to the ‘tragedy’ is whenan individual participates in consumption, they are not considering the wider impact on (specifically but not exclusively) ecosystems and the wider world. This is causing progressive worry and strain on the sustainability of our planet.

A Perfect Perfectly Competitive Market

As some would argue there are wealth of examples of perfectly competitive markets, I believe there are few. However, this doesn’t mean none; I think the Foreign Exchange market is the best example of a perfectly competitive market, as do many others when trying to teach this concept. This is because the Forex market is bound by the constraints of the market confining traders resulting in the achievement of a perfectly competitive market: no one individual can ever control or influence the price, with that nobody has a significant market share; there are no barriers to entry or exit of the market, therefore there are (in theory) zero costs when entering and exiting the market, a rarity; and there is identical goods being sold with perfect information in the market, there is complete transparency with no one party knowing more than another.

These collective conditions derive a perfectly competitive market and due to the nature of the Forex market, are sustained.This is unique in itself, as markets evolve and maybe one day were perfectly competitive but now are not. The Forex market, however, has always been as good an example as economists can identify as a perfectly competitive market.