Chapter 2
Economic Efficiency and
Markets: How the Invisible
Hand Works
Static Efficiency, pp. 14-32
© 2004 Thomson Learning/South-Western
The Working of the Invisible Hand

Adam Smith’s The Wealth of Nations argues that
markets lead to socially efficient allocation of
resources. People acting in their own best interests
tend to promote the social interest.

Anti-globalization protestors counter that free
markets are the root of all social evils.

The truth probably lies somewhere in between.
2
Market Fundamentals



Begin by looking at an every day private
good.
The goal is to understand the differing
components of a market.
After we understand how a market works, we
can add the complexity associated with the
impact of market activity on the environment,
and the impact of the environment on market
activity and society in general.
3
Figure 2.1 – Market for Blue Jeans
4
The Market for Blue Jeans: supply

The marginal cost is the cost of producing one more
unit of a good. These costs include:




labor,
energy,
machinery,
and other materials.

Marginal Cost = Supply in competitive markets

Market supply is the sum of individual firm supply
curves
5
The Market for Blue Jeans: supply
$
S1
S2
Market supply is a horizontal summation
of individual supply curves
S = S1+S2
Q
6
The Market for Blue Jeans: demand


The downward sloping function is the demand curve
Demand represents how much people are willing to
pay for an additional pair of jeans. Individual
demand is influenced by:





tastes and preferences,
prices of substitutes and complements,
income,
and consumer expectations.
Individual demand is also interpreted as
Marginal Benefit = value attached to each
additional unit of the good
7
The Market for Blue Jeans: demand
$
D = D1+D2
D1
D2
Market demand is a horizontal
summation of individual demand curves
Q
8
The Market for Blue Jeans

Equilibrium price is the price at which quantity
demanded equals quantity supplied.

What happens when price is not at equilibrium?
There is an automatic adjustment back to
equilibrium.


If price is less than equilibrium (P*), then quantity
demanded will be greater than quantity supplied and
there will be pressure on price to rise (up to
equilibrium).
If price is greater than equilibrium (P*), then quantity
supplied will be greater than quantity demand and
there will be pressure on price to fall (down to
equilibrium).
9
Figure 2.1 – Market for Blue Jeans
Phigh
Plow
10
Why are economists so often so enamored
with markets??

The demand curve can viewed as a marginal
value function based on willingness to pay.




The market demand curve is the sum of all
individual demand curves.
Every individual demand curve reflects a
willingness to pay based on a perceived value (or
benefit) of the good.
Everybody counts!
As a result, the market demand curve reflects
private benefits.
11
Measuring Net Benefits



The supply curve reflects the costs of
producing the good or service.
These costs are incurred in production and
can be viewed as private, since all these
costs are borne by the suppliers.
As such, the supply curve embodies private
costs.
12
Figure 2.1 – Market for Blue Jeans
• Total benefit equals the
area under the demand
(marginal benefit curve)
A
•What is the total benefit
to consumers when Q* is
produced?
B
C
•What is the total cost to
producing Q* ?
13
Measuring Net Benefits

If we make two simple assumptions:


All costs associated with blue jeans are
incorporated into the supply curve.
All the benefits associated with blue jeans are in
the demand curve.

Then equilibrium in this market also equates
marginal benefits with marginal costs.

The market maximizes total net benefits.
14
Summary: Maximizing Private and Social
Benefits





Private net benefits are maximized at equilibrium.
In order for social net benefits to be maximized, it is
necessary that private marginal benefits be identical
to social marginal benefits and private marginal
costs be identical to social marginal costs.
If this condition holds, then market forces will equate
both marginal private costs and benefits and
marginal social costs and benefits.
Efficiency = Maximizing social net benefits
Aren’t markets great ??
15
Market Failure: When the Invisible Hand
Doesn’t Work


Market Failure occurs when the market does not
allocate resources efficiently.
There are 5 categories of market failure:

Imperfect competition.

Imperfect information.

Public goods.

Inappropriate government intervention.

Externalities.
16
Imperfect Competition




Imperfect competition occurs when the individual
actions of particular buyers or sellers have an
impact on market price.
Monopoly = a single seller
Examples of monopoly: Ma Bell, company stores,
electricity (regulated), etc.
Market failure due to imperfect competition has an
impact on the study of environmental and natural
resources because of the monopoly power in
extractive industries such as oil and coal.
17
Monopoly – 1 Seller who controls the
market
$
Marginal Cost
P1
Marginal
Revenue
Demand
Q1
Q*
Quantity
18
Figure 2.4. Imperfect Competition
19
Monopoly (imperfect competition)




Creates Market Failure
In imperfectly competitive markets, marginal
revenue diverges from price and marginal
social cost is not equal to marginal social
benefit at equilibrium.
Monopoly is Inefficient
Why else don’t we like monopoly? (Why
doesn’t Ralph Nader like monopoly?)
20
Imperfect Information


Imperfect information means that some segment of
the market (either consumers, producers, or both)
does not know the true costs or benefits associated
with the good or activity.
For example:



High risk occupations where workers do not have
complete information about risks (asbestos workers)
Hazards of using chemicals in your home where you
may not be fully aware of dangers and potential sideeffects.
Potential that farmers in developing countries are not
aware of environmentally friendly alternatives to clear
cutting.
21
Public Goods

Public goods are distinguished from private goods
by two primary characteristics: nonrivalry and
nonexcludability.

Nonrivalry means that one individual’s consumption
does not diminish the amount of the public good
available for other’s to consume.

Nonexcludability means that if one person has the
ability to consume the public good, then others can’t
be excluded from consuming it.
22
Public Good



National defense is an example of a pure
public good.
Nonexcludability holds because in protecting
one citizen in a region from missile attack,
every citizen is protected.
Nonrivalry holds because one citizen’s
consumption of protection does not reduce
the level of protection available to other
citizens.
23
Public Good

Not all public goods are pure public goods.

It is possible to build a long fence around the
Grand Canyon to exclude people.

It is also true that beyond some point, more
people at the Grand Canyon reduces the
quality of the experience for everyone.
24
Figure 2.5 Spectrum of public goods
25
Public goods: Demand
Market Demand = VERTICAL sum of demands
$
DA
DB
Marginal Cost
QB
QA
Q*
Quantity
26
Public Goods, inefficient outcome of free
market

Generally, too FEW public goods provided by free
market

Free riding = get enjoyment out of public good
provided by others without paying for it

Does this happen?

Government provision of public goods with taxation
to pay for them is often justified based on these
inefficiency arguments
27
Inappropriate Government Intervention



Government intervention is a potential source
of disparity between private and social
values.
Government action to address an alternative
issue may create a divergence.
Government policy regarding leasing of
timbering has created a greater than socially
optimal level of timber harvest.
28
Figure 2.6 – Inappropriate Government
Intervention
29
Unintended Consequences
By STEPHEN J. DUBNER and STEVEN D. LEVITT, NY Times
Magainze: January 20, 2008
The Case of the Red-Cockaded
Woodpecker

Endangered
Species Act
unintended effects
on habitat?
30
Externalities



A common cause of market failure is the
divergence externalities create between
private and social costs.
Consider a production process which reflects
all the private costs of production but does
not reflect all the social costs associated with
production (for example, if the process
generates air pollution).
Now, marginal social cost is different from
marginal private cost
31
Externality: Pollution from a factory
$
Marginal
Damage from
pollution
Quantity of Steel Output
32
Figure 2.3. Steel Production Example
MSC = MPC + Marginal Damage from pollution
33
Market Failure




Market forces generate an equilibrium production
level and price associated with private costs (Q1
and P1).
This output level is greater than the socially optimal
level of Q* (which considers additional cost from
pollution).
The shaded area in Figure 2.3 represents the costs
to society of having this higher than optimal level of
output. TOO MUCH output is generated by the free
market
Shaded area = “deadweight loss” or lost social “net
benefits” from too much production
34
Externalities



Externalities are best described as “spillover
costs or benefits”, unintended consequences
or side effects, associated with market
transactions.
These unintended costs or benefits will result
in a divergence between private and social
benefits and costs
Externalities are perhaps the most important
class of market failures for the field of
environmental and resource economics.
35
Externalities


A more complete definition is provided by
Baumol and Oates (1988, p.17)
“An externality is present whenever some
individual’s (say A’s) utility or production
relationships include real (that is
nonmonetary) variables, whose values are
chosen by others (persons, corporations,
governments) without particular attention to
the effects on A’s welfare.”
36
Unintended Effects



If you were intentionally blowing cigar smoke
in someone’s face, that is not an externality.
If your cigar smoke drifts from your table to
someone else’s, then this is an externality.
Intent is important.
37
Real Variables



Real variables are not prices.
Unintended price change is not an externality.
Price changes are viewed as “pecuniary
externalities”, not real.
38
Production and Utility Relationships




Air pollution has the potential to impact both
production and utility relationships.
Air pollution may create a less ideal growing
condition and impact yields.
Air pollution may also make outdoor activities
less enjoyable (reduce utility).
These are examples of technological
externalities.
39
Technological vs. Pecuniary Externalities




Consider Figure 2.8 which represents a production
possibilities frontier for two goods: cotton and steel.
The production possibilities frontier shows all
feasible production points.
Consumer preferences determine the actual
combination of cotton and steel produced.
A change in consumer preferences will result in a
change in demand, which changes prices and profit
potential, which, in turn, will cause a change in
production levels of both goods (along the same
production possibilities frontier). This is a pecuniary
externality. NOT A CAUSE FOR GOVERNMENT
INTERVENTION, just the free market at work!
40
Figure 2.8- Production Possibilities
Frontier
41
Technilogical vs. Pecuniary Externalities




What happens if cotton production was
damaged by steel generation?
Suppose pollution reduces the yield per acre
of cotton with the existing resource base.
A new lower production possibilities curve
results from this externality.
This is a technological externality.
Technological externalities can be a cause for
government intervention --- market failure
42
Externalities as Public Goods


Referred to as nondepletable externalities,
these are characterized by the public good
property of nonrivalry.
Air pollution that obscures a beautiful view is
a good example where one person’s
consumption of the externality (seeing the
pollution) does not reduce the amount of
pollution to which others are exposed (next
guy that drives by still see cruddy view).
43
Market Failure and Property Rights:
Open-access probolems



A special class of externality that is generated
by the lack of property rights (or the inability
to enforce property rights) is the open-access
externality.
In this case property rights are insufficient to
prevent general use of a resource and
uncontrolled use leads to destruction or
damage of the resource.
We will discuss this type of externality in
detail later when we discuss renewable
resource problems, fisheries and wildlife very
susceptible to open-access problems
44
The Invisible Hand and Equity





Market allocation of resources, absent of market
failure, is efficient.
An efficient allocation maximizes the difference
between social benefits and social costs.
An efficient allocation, however, does not imply
equitable allocation.
The “best” distribution depends on what view of
equity or fairness is held.
Some (many?) arguments for government
intervention relate to equity, what we have studied
here are arguments based on efficiency, getting the
most value for the most people
45
Conclusion



The bulk of this chapter focuses on markets
and how markets efficiently allocate goods
and services.
When market failure occurs, marginal private
benefits diverge from marginal social benefits
and marginal private costs diverge from
marginal social costs.
Market failure results from externalities,
public goods, imperfect information, imperfect
competition, and inappropriate government
intervention.
46