Market Failures and Efficiency in the Principles Course

Abstract

Many policy debates revolve around the appropriate extent and form of government intervention in specific markets, or, more accurately, government alteration of the incentives or institutional rules in those mar kets, including the provision of certain goods. 1 To make sense of these debates, economics students must understand what “free” markets do well and, in particular, where they fail, and how governments may be able to improve their behavior. Toward this end, authors of principles textbooks generally discuss concepts including gains from trade, efficiency, the invisible hand, and various causes of market failures such as market power, externalities, and public goods. The current pedagogy fails to emphasize fully the common principles under lying the various categories of market failure. The examination of principles text books below demonstrates that each category of market failure is typically dis cussed separately. Furthermore, the textbooks do not always clearly show how an economist identifies the alternati ve, preferred outcome, nor do they emphasize that economists often apply an efficiency criterion in considering alternati ves. I argue instead for a unified consider ation of how markets fail, based on how an ef ficiency rule is violated . All market transactions can be characterized as “ef ficient”or “inefficient,”according to whether they satisfy the ef ficiency rule that marginal benefits to society equal or exceed marginal costs to society. Then, all explanations of individual market failures can refer to this rule and show ho w private-decision rules may sometimes deviate from it. Finally, one can show how government, by making alterations to individual markets (by changing rules or incentives or by providing goods directly), may be a ble to impr ove the efficiency of the economy. This unified consideration does not require rear rangement of topics within the course, other than introduction of the ef ficiency rule at some point before the first type of mar ket failure is taught. A unified treatment of mar ket failures and efficiency has two key benefits. First, consolidation enables reinforcement of the basic concepts through r epetition of the same analytical constructions and may also lessen the class time required to cover market failures. Second , consolidation conveys to students that economists often reference a common normative foundation, based on the con