Question

How do free competitive markets maximize social welfare? In addition, what are market failures and how do they affect social welfare?

Answer 1

Answer 1

Perfect competition is only one way for attaining welfare maximisation. A decentralised socialist system, for example, in which the government has somehow estimated ‘shadow’ prices and directs its individual economic units to maximise their ‘gains’, can in principle achieve the same results as a perfectly competitive system.

In summary, Implicit in the purely ‘technocratic’ problem of welfare maximisation is a set of ‘prices’. Decentralised decisions in response to these ‘prices’ by atomistic profit maximisers and utility maximisers will result in just that levels of inputs, outputs and commodity-distribution that the bliss point requires.

The individual maximisers can be acting in a perfectly competitive system, or in a decentralised social system of the Lerner-Lange type, where bureaucrats have established somehow the ‘prices’ that maximise social welfare and coerce the citizens to act in response to these ‘prices’.

Duality theorem’ is the kernel of modern welfare economics. This ‘dua­lity theorem’ may be stated as follows. Welfare maximisation can be attained by maximising behaviour of individuals, given the technological relations of the produc­tion function, ordinal indexes of the utility of consumers, and given a social welfare function. The welfare maximisation is independent of prices.

However, implicit in the logic of this purely technocratic formulation is a set of constants. These constants can be the prices of a perfectly competitive economy, or the ‘shadow prices’ of a socialist economy. Thus, if these ‘prices’ (constants) are known (as, for example, the prices of a perfectly competitive system), and individual profit maximisers and utility maxi- misers act in response to these prices, their behaviour will lead to the maximisation of social welfare.

Answer 2

Market failure” is a common justification for new government policies. Proponents of interventions love to point to instances of apparently imperfect markets and assume that government taxation, subsidies, and regulation can seamlessly perfect them, thus maximizing social welfare.

Academic economists have long doubted this way of thinking. Comparing market outcomes to some unattainable and unidentifiable ideal is not useful in a world of imperfect knowledge and government failure. It is far better to compare outcomes from an intervention against actual realistic alternatives. Yet public debate often seems stuck on this rudimentary understanding of what market failure is and how it should be dealt with.

Worse, in many instances this basic framework of market failure is misused, leading to misguided policies. Government services, for example, are often labeled public goods even when they do not fulfill economists’ definition of public goods as being nonrivalrous and nonexcludable, and in situations where markets have clearly found means of delivery without government. This creates the public perception that some goods and services must be provided by government simply because they are or could be.

Likewise, proponents of Pigouvian taxation to address negative externalities often exaggerate how high these taxes should be by including private costs (such as lost productivity) as external costs, failing to apply the logic of dealing with externalities consistently, and ignoring how taxes affect the demand for substitute products, which themselves can generate negative externalities. Externality arguments are also often used to justify uniform consumption taxes even when only certain consumption levels generate the external costs, and they are increasingly used to justify outright bans on various goods. Both responses can lower social welfare.