Question

Explain why economic efficiency cannot be achieved under certain circumstances.

Answer 1

Economic efficiency cannot be achieved under certain circumstances but before that let's discuss what is Economic efficiency

Economic Efficiency refers to the situation where some people cannot be made better-off by reallocating the resources or goods, without making others worse-off. It indicates that a balance between benefit and loss has been achieved. Also called allocative efficiency.

Thus “economic efficiency” is defined as the use of resources in order to maximize the production of goods and services.

Now let's discuss under which circumstances economic efficiency cannot be achieved or reasons for economic inefficiency or market failure.

Circumstances are:

1)Externalities

2)Public Goods

3)Increasing returns to scale

Externalities:

An externality is a cost or benefit that results from an activity or transaction and affects a third party who did not choose to incur the cost or benefit. An example of a externality is pollution. Manufacturing plants emit pollution which impacts individuals living in the surrounding areas. Third parties who are not involved in any aspect of the manufacturing plant are impacted negatively by the pollution.

Thus

One problem arises if consumption or production causes external effects—that is, if one person’s consumption or one firm’s production imposes costs or benefits on other consumers or producers. In essence, an externality exists if one economic agent’s action (consumption or production) affects another agent’s welfare outside of changes in market prices or quantities.

Public Goods:

A public good is a good that is both non-excludable and non-rivalrous. This means that individuals cannot be effectively excluded from its use, and use by one individual does not reduce its availability to others. Examples of public goods include fresh air, knowledge, lighthouses, national defense, flood control systems, and street lighting.

Public goods is a reason for economic inefficiency that leads to what is called the free-rider problem. The free-rider problem is that some people may benefit from a public good without paying their share of the cost.

Since public goods are non-excludable, free-riders not only can’t be prevented from using the good, but actually have an incentive to continue to free-ride. If they will be able to use the public good whether they pay their share of the costs, they might as well not pay.

Take the military, for example. National security is a public good: it is both non-rivalrous and non-excludable. In order to have such a public good, everyone pays taxes which are then used by the government to finance the military. However, there are undoubtedly people who have not paid their taxes. These people, without having paid their share of the cost of having a military, still benefit from the protection the military provides. They are free-riders.

Another example is a lighthouse. After a lighthouse is operating, an additional ship can be guided by the light while others are using it, and it could be very expensive to enforce a “lighthouse use fee” on ships that come in view of the light.

Increasing returns to scale

The first stage, increasing returns to scale (IRS) refers to a production process where an increase in the number of units produced causes a decrease in the average cost of each unit. In other words, a firm is experiencing IRS when the cost of producing an additional unit of output decreases as the volume of its production increases. IRS may take place, for example, if the cost of production of a manufactured good would decrease with the increase in quantity produced due to the production materials being obtained at a cheaper price.

A efficiency problem for competitive markets

For instance, if doubling the labor, land, and capital cause output to more than double, then average production costs decrease as output increases. If Total Cost and the amounts of labor, land, and capital are doubled, then total cost doubles; but if twice as much of each input causes output to more than double, average cost falls. If average cost is decreasing, then marginal cost must be less than average cost at all output amounts (because average cost is decreased by more production if the extra cost of producing one more unit is less than the existing average cost). This situation often applies to public utilities, including communications, electricity, natural gas, water, sewer, or transit services, all of which have large capital requirements even to serve a few customers. Industries with increasing returns to scale are often called natural monopolies because it makes sense to have only one producer rather than multiple producers duplicating the required infrastructure.