6.1 Socially Efficient and Inefficient Market Outcomes

a. Define social efficiency. b. Explain (using graphs where appropriate) why resource allocation in perfectly competitive markets is socially efficient.

• The optimal quantity of a good occurs where the marginal benefit of consuming the last unit equals the marginal cost of producing that last unit, thus maximizing total economic surplus.
• The market equilibrium quantity is equal to the socially optimal quantity only when all social benefits and costs are internalized by individuals in the market. Total economic surplus is maximized at that quantity. [See also PRD-3 and POL-3.]
• Enduring understanding POL-2: Perfectly competitive markets allocate resources efficiently, but imperfect competition often results in market inefficiencies.

Explain (using graphs where appropriate) how private incentives can lead to actions by rational agents that are socially undesirable (inefficient) market outcomes.

• Rational agents can pursue private actions to exploit or exercise market characteristics known as market power.
• Rational agents make optimal decisions by equating private marginal benefits and private marginal costs that can result in market inefficiencies.
• Policymakers use cost-benefit analysis to evaluate different actions to reduce or eliminate market inefficiencies.
• Market inefficiencies can be eliminated by designing policies that equate marginal social benefit with marginal social cost.
• Enduring understanding POL-2: Perfectly competitive markets allocate resources efficiently, but imperfect competition often results in market inefficiencies.

a. Explain equilibrium allocations in imperfect markets relative to efficient allocations (using graphs where appropriate) and why these markets are inefficient. b. Calculate (using graphs where appropriate) the deadweight loss resulting from the production of a non-efficient quantity.

• Equilibrium allocations can deviate from efficient allocations due to situations such as monopoly; oligopoly; monopolistic competition; negative and positive externalities in production or consumption; asymmetric information; and insufficient production of public goods.
• Producing any non-efficient quantity results in deadweight loss.
• Enduring understanding POL-2: Perfectly competitive markets allocate resources efficiently, but imperfect competition often results in market inefficiencies.