Question

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

Answer 1

Free competitive markets are those where the equilibrium is reached by the forces of demand and supply without any intervention. This means that the price is such that the sellers are selling the quantity that buyers are buying and there is no shortage and surplus. Each of them have perfect information and hence are able to maximise their surplus which means that the social welfare is maximised.

Market failures are when market fails to allocate the resources in the market efficiently. This could be due to presence of Externalities, taxes , subsidies etc. These market failure cause society losses known as the welfare loss or deadweight loss. This deadweight loss is the cause of loss of social welfare.

Eg: If there is negative externality of pollution which affects the fisheries , then the social optimal is not equal to private optimal. This means that the external cost is not included in private costs and so more quantity is produced. This means there is deadweight loss and this leads to social welfare loss.

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