1.
Economic Efficiency and Markets:
How The Invisible Hand Works
Chapter 2
1

2.
Efficient and optimal allocation of goods
• Given ideal conditions, markets allocate goods efficiently.
• These ideal conditions are:
1. All goods and services are private goods.
2. Markets exist for all goods & services produced and consumed
3. All markets are perfectly competitive.
4. All agents are rational with perfect information.
2

3.
Market Equilibrium
3

4.
How The Invisible Hand Works
4

5.
Market failure: When the Invisible Hand does not Work
• The inability of the market to allocate resources efficiently is called market
failure.
• Market failure occurs when the market outcome does not maximize
netbenefits of an economic activity.
• Due to the nature of environmental resources, the market often fail in
dealing with environmental resources.
• Why do markets fail?
5

6.
Market failure
• Why do markets fail?
6

7.
Social welfare
7
• Social Welfare is not maximized
• If
• MPB ≠ MSB
• MPC ≠ MSC

8.
Market failure
• There are following main reasons for market failures in case of
environmental goods.
• Imperfect Competition
• Incomplete information
• Externalities
• Inappropriate government intervention
• Public Goods and the Free-rider problem
• Property Right
8

9.
Four Conditions for Perfect Competition
1. Many buyers and sellers
People have lots of options to choose whom they buy from.
2. Identical Products
There are no differences between what is sold by different suppliers.
They are exactly the same!

10.
Four Conditions for Perfect Competition
3. Informed Buyers and Sellers
Buyers know the prices and quality of product sold by all venders to
make the best decision
4. Free Market Entry and Exit
Businesses can enter the market when they can make money
and exit when they can’t.

11.
Perfect Competition
• If market is perfectly competitive:
• Equilibrium condition:
• MC=MR
• AR=AC=MC=MR=P
• MR=P
11

12.
(a) Firm
d=AR+MR
(b) Industry or market
Q
Quantity
per period
0
q
Quantity
per period
0
MC
ATC
Dollars
per
unit
p
Price
per
uni
t
p
S
D
e
Long-Run Equilibrium for a Firm and the Industry

13.
Imperfect Competition
• Monopoly
• Def. a market dominated by a single seller.
• They take advantage of their monopoly power and charge high prices.
13

14.
Imperfect Competition
14

15.
Imperfect Competition
• Imperfect markets do not allocate goods efficiently
15

16.
Incomplete information
• Imperfect information means that either consumer or producer or
both …….does not know the true cost and benefits associated with
good or activity.
• MPB ≠ MSB
• MPC ≠ MSC
• In such a situation market fails to make efficient allocation of
resources.
16

17.
Externality
• Externality: “An economic side-effect.
• Externalities are costs or benefits arising from an economic activity
that affect somebody other than the people engaged in the economic
activity and are not reflected fully in prices.”
• Externalities Cause Market Failure
17

18.
Externality
• An Externality results when the actions of an individual/firm have
direct, unintentional, and uncompensated effect on the well-being of
other individuals or profits of other firms.
• Direct: There has to be a direct effect on well-being of an identifiable
individual(s) or profits of firms.
• Unintentional: The effect rather than the action has to be
unintentional.
• Uncompensated: The responsible actor is not compensated for their
actions.
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19.
Examples of Externalities
• Cigarette smoking.
• Air pollution from factories and power plants.
• If a neighbor keep their houses and flower gardens well maintained,
the value of the houses in that neighborhood is likely to rise.
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20.
Externality
• Externalities are classified as:
• Consumption to consumption
• Production to consumption
• Consumption to production
• Production to production
20

21.
Externalities
21

22.
Externalities
22

23.
Externalities
• The inefficiency is caused by an externality.
• Market fails to allocate efficiently
• Market Failure
23