11 Problems with the Private Sector
11.1 Introduction to economic efficiency
In this chapter, we will discuss situations where the free market does not provide the most efficient outcome. These situations include:
- Market power (lack of competition)
- Externalities
- Public goods and the free rider problem
- Information problems
Before we can talk in more detail about these situations, we must discuss economic efficiency in more depth.
The Demand Curve and Benefits
Recall, the demand curve shows us different combinations of prices and the quantity demanded at those prices. But, where does this come from? But we can also think about this another way…how much are you willing to pay for a certain quantity of a good. Consider this demand schedule for an individual:
| P | Qd |
|---|---|
| $10 | 0 |
| $8 | 1 |
| $6 | 2 |
| $4 | 3 |
| $2 | 4 |
Notice that as someone consumes more, they are willing to pay less for the additional units. As mention earlier this semester, this is due to the law of diminishing marginal utility. Consumers receive less and less additional benefit from each additional unit from consumption. Since they are getting less, they are not willing to pay as much. Thus, the (maximum) price you are willing to pay for an additional unit is the additional benefit you will receive from consuming that unit. Therefore, we can think of the demand curve as a marginal benefit curve. Thus, you can view the demand curve as a marginal benefit curve. That is, the demand curve will also show you the marginal benefit of an additional unit of consumption.
The Supply Curve and Costs
Recall, in the short-run, as we increase the quantity produced of a good in the short-run, we face an increasing marginal cost. Therefore, the 4th good costs more to produce than the 3rd good, and so-on. As the cost of manufacturing a good increases, the amount of money the supplier will require will increase. A firm is willing to increase how much it supplies…if people are willing to pay the higher additional costs. Therefore, the supply curve is really just another way to illustrate costs. The least a firm would be willing to accept for a good is the cost of manufacturing the good. Thus, the supply curve is a marginal cost curve.
Equilibrium and Efficiency
In chapter 3, we saw that a market is in equilibrium when the quantity demanded is equal to the quantity supplied. The same applies here. A market is in equilibrium when the marginal benefit of production is equal to the marginal cost of production. When a market is in equilibrium, we consider it to be economically efficient. This is shown below:
Economic inefficiency occurs in two situations:
- When too much is produced which would cause the marginal cost of production to exceed the marginal benefit of production. This means that it is costing more to produce the additional units than the benefits it is producing.
- When too little is produced which would cause the marginal benefit of production to exceed the marginal