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When do markets work?
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About the lecture
In this module, we look at the situations when markets work. In particular, we look at: (i) how the free market works and under which conditions it achieves an efficient allocation of resources; (ii) the fundamental theorems of welfare economics; (iii) Pareto efficiency; (iv) what happens in situations of excess demand and supply in an efficient market; and (v) the conditions needed for free markets to achieve efficiency.
About the lecturer
Maria Cubel is a Senior Lecturer in Economics at the University of Bath. She specialises in the fields of applied microeconomics and experimental economics with a particular focus on labour economics, gender economics, public economics, inequality, and contest and conflict. With this in mind, she has written widely, including ‘Difference-form group contests’ (Review of Economic Design, 2022) and ‘Gender, competition and performance: evidence from chess players’ (Quantitative Economics, 2022).
Hello.
00:00:05My name is Dr Maria Campbell and I'm senior
00:00:06lecturer in economics at the University of Path.
00:00:09In this course, I'm going to talk about market failures.
00:00:12In this lecture,
00:00:16I would like to explain how the free market works and
00:00:17under which conditions it achieves an efficient allocation of resources.
00:00:20I will then move to describe what we call market failures
00:00:25to understand whether free markets are efficient and
00:00:29no intervention from the government is needed.
00:00:33We will use as framework of analysis the principles
00:00:36of welfare economics from the perspective of welfare economics.
00:00:40An ideal market should maximise social welfare.
00:00:44In order to maximise social welfare markets must
00:00:48ensure an efficient and equitable allocation of resources.
00:00:52Let me now use the fundamental theorems of welfare economics to express if I
00:00:57how the free market achieves efficiency and
00:01:03equity in the allocation of scarce resources.
00:01:06The first fundamental welfare theorem states that
00:01:10competitive market lead to Pareto efficiency.
00:01:14We say that an allocation is Pareto efficient when it's not possible to increase the
00:01:17welfare of one individual without decreasing the
00:01:24welfare of another individual in the process.
00:01:27Thus,
00:01:30a Pareto efficient allocation of resources is one for which there is no way to
00:01:31make at least one economic agent better off without making someone else worse off.
00:01:37The second fundamental theorem of welfare
00:01:44economics states that anybody to efficient allocation
00:01:47in the economy can be achieved as the equilibrium of competitive markets,
00:01:52provided that we redistribute income and wealth in the correct way.
00:01:57Therefore, the second fundamental welfare theorem opens the door to government,
00:02:03intervening in the economy as a way to ensure that markets
00:02:09lead to an efficient but also equitable allocation of resources.
00:02:13Let me now describe how the free
00:02:18market achieves an efficient allocation of resources.
00:02:21As we just said,
00:02:24the first fundamental theorem of welfare economics states that competitive
00:02:26markets lead to Pareto efficient allocations in competitive markets.
00:02:31All economic agents take, prices has given,
00:02:36and it's through the price mechanism that information is transmitted when you go
00:02:40to a shop and see that the price of a good is high.
00:02:47That means that the good is relatively scarce,
00:02:51either because it's costly to produce or because it's heavily demanded.
00:02:54When the amount produces wish to sell at a given
00:03:00price coincides with the amount consumers want to buy.
00:03:03At that price, we say that the market is in equilibrium.
00:03:07In other wars,
00:03:12the wishes of producers and consumers coordinate through the price system.
00:03:13If the price is very high,
00:03:19it is likely that there will be an excess of supply in the market,
00:03:22since the amount producers would like to sell at that price is
00:03:27likely to be larger than the amount consumers want to demand.
00:03:31The market price is then likely to decrease.
00:03:36If the price is very low,
00:03:41it's likely that consumers will demand a larger amount than
00:03:43the one producers are willing to offer at that price
00:03:47and access demand and shoes.
00:03:51And the price is likely to move up when the price reaches.
00:03:53The point where the amount producers want to sell is
00:03:58the same as the amount consumers want to buy.
00:04:01The market is in equilibrium.
00:04:04Now.
00:04:06Let me describe how consumers and produces
00:04:07reach their optimal decisions in competitive markets.
00:04:10Taking prices has given consumers choose the combination
00:04:14of goods and services that maximises their welfare.
00:04:19Producers, on the other hand,
00:04:23choose to sell the amount of goods and services that maximise their profit
00:04:25to maximise the world fair on or the prophet.
00:04:31Consumers and producers compare the costs and benefits of their choices.
00:04:35Taking prices has given the optimal choice is
00:04:41the one for which the benefit of buying or
00:04:45selling one additional unit is equal to the
00:04:48cost of buying or selling that additional unit.
00:04:52When this condition is repeated,
00:04:56there are no further benefits of trading in the market,
00:04:59and an efficient allocation of resources is achieved.
00:05:03The remarkable feature of the first fundamental welfare theorem is that,
00:05:07in essence,
00:05:13it states that the optimal decisions of economic agents pursuing their own benefit
00:05:14when aggregated in a competitive market lead
00:05:20to an efficient allocation of resources.
00:05:24Okay, so far,
00:05:27we have emphasised a lot that competitive markets lead to parade efficiency.
00:05:29But what about equity to markets produce for an equitable allocations?
00:05:34This is a tricky question, because at the end of the day,
00:05:39the concept of efficiency is a technical one.
00:05:42But the concept of equity is quite subjective and calls for value judgement.
00:05:46There are many different allocations of resources which might
00:05:51be considered fair or equitable under different value judgments.
00:05:55That said, it is possible to say something about equity and markets. For that.
00:06:00Let me come back to the second fundamental theorem of welfare economics.
00:06:06As I mentioned earlier,
00:06:12the theorem states that is possible
00:06:13to reach anybody to efficient allocation through
00:06:16competitive market by redistributing initial wealth
00:06:19and income with the adequate transfers.
00:06:24The selection of a specific Pareto efficient
00:06:29allocation is a choice related to equity,
00:06:31not to efficiency.
00:06:35Moving from one Pareto efficient allocation to another one implies that
00:06:37some individuals get worse off while others become better off.
00:06:42Therefore,
00:06:48choosing a particular Pareto efficient allocation depends on
00:06:49our concept of what is socially desirable.
00:06:53It's a redistributive decision.
00:06:57What is important, according to the second fundamental welfare theorem,
00:07:00is that the free market allows us to achieve our desirable,
00:07:05Pareto efficient equilibrium by redistributing resources in the right way
00:07:10to sum up according to welfare economics,
00:07:17competitive markets produced efficient and equitable allocations of resources.
00:07:20However,
00:07:27for free markets to work well and be efficient,
00:07:29quite a few conditions must be satisfied.
00:07:33Those conditions are the following
00:07:37first, markets must be perfectly competitive.
00:07:40Second, economic agents must have perfect information.
00:07:44Fair property rights must be well defined.
00:07:49Fourth markets should be complete and fifth agents must behave rationally.
00:07:54Let me provide more detail on each of these conditions.
00:08:02The first condition is that markets must be competitive.
00:08:07There is perfect competition when no economic agent,
00:08:12consumer or producer can determine the price of any good or service in the market.
00:08:16In other words, no economic agents should have market power.
00:08:24When there is perfect competition, no one can affect the prices.
00:08:29And we say that economic agents are price takers
00:08:34to have perfect competition.
00:08:38We need many consumers and many sellers with no barriers to enter
00:08:40and operate in the market or to buying and selling their products.
00:08:46The second condition is perfect information.
00:08:52There is perfect information when all agents in
00:08:55a transaction have access to the same information,
00:08:59so there is no mass symmetric information,
00:09:03and no agent has an informational advantage.
00:09:05The third condition is that property rights must be well defined.
00:09:10This means that property rights are well
00:09:15specified and assigned so that there is always
00:09:18an economic Asian who is the owner of the good or service to be traded.
00:09:22Furthermore,
00:09:28markets should be complete so that one can buy or sell anything in the market.
00:09:30There must be a market for everything consumers want to buy,
00:09:36and producers want to sell.
00:09:40Finally, economic agents should be rational.
00:09:43This means that economic agents take actions to attain their own objectives.
00:09:47To do so,
00:09:53economic agents should evaluate the benefits and
00:09:54costs of their potential actions and decisions
00:09:58and choose the ones that procure them the highest benefit according to their goals.
00:10:01When one or more of these conditions do not hold, we say that the market fails.
00:10:08In that case,
00:10:15the allocation of resources that markets generate
00:10:16may not be efficient or equitable,
00:10:20and the public sector or, in other words,
00:10:23the government can intervene to correct the market failure.
00:10:25To conclude this lecture,
00:10:31the ME distinguish the following types of market failures market
00:10:32failures due to the lack of well defined property rights.
00:10:36This includes the case of public goods and externalities market failures.
00:10:40Due to the absence of perfect competition,
00:10:45there is no perfect competition when producers or consumers can
00:10:48affect the price of goods or services in the market.
00:10:53Examples of imperfectly competitive markets are monopolies,
00:10:57natural monopolies, oligopolies and monopolies. Unease.
00:11:02Finally, we can have market failures because of imperfect information,
00:11:07the two main market failures due to imperfect information, our moral hazard
00:11:13and adverse selection.
00:11:19In the next lectures, we will study in detail each of these types of market failures
00:11:21
Cite this Lecture
APA style
Cubel, M. (2022, December 07). Resource Allocation - When do markets work? [Video]. MASSOLIT. https://massolit.io/options/resource-allocation?auth=0&lesson=11021&option=5626&type=lesson
MLA style
Cubel, M. "Resource Allocation – When do markets work?." MASSOLIT, uploaded by MASSOLIT, 07 Dec 2022, https://massolit.io/options/resource-allocation?auth=0&lesson=11021&option=5626&type=lesson