Market Inefficiency

Wouldn't it be lovely if that cup of coffee was sold for exactly how much it cost to make it? Now, wouldn't it be lovely if you were paid a salary that is directly equal to the value of the product you made for the company? If your answer is yes, then you would be helping create an efficient market. This is because for market inefficiency to occur, you would have to take a salary that exceeds the value of the work you did. Continue reading for an interesting discussion on market inefficiency.

Market Inefficiency Market Inefficiency

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Table of contents

    Market Inefficiency Meaning

    What is the meaning of market inefficiency? To explain this properly, let's first tell you what an efficient market is. In an efficient market, economic agents are getting as much benefit as possible from their limited resources. In other terms, their costs are matching their benefits perfectly. An inefficient market is the direct opposite of this. Market inefficiency refers to a situation where markets are unable to achieve the optimal outcome and the transactions are not mutually beneficial.

    Market inefficiency refers to a situation where the transactions in a market are not mutually beneficial and the market fails to achieve the optimal outcome.

    The optimal outcome is the outcome in which the benefits match the cost. For a product, the optimal quantity is the quantity where the marginal benefit of consuming one more unit is equal to the marginal cost of producing that unit. When this happens, the total economic surplus has been maximized!

    The optimal outcome is the outcome in which the benefits match the cost.

    The optimal quantity of a product is the quantity where the marginal benefit of consuming one more unit is equal to the marginal cost of producing that unit.

    The total economic surplus is maximized when the benefits fully account for the costs.

    Market efficiency is achieved in a perfectly competitive market when equilibrium is reached. Here, the equilibrium quantity of the market is equal to the socially optimal quantity only when the costs and benefits are internalized by economic agents. What does all this mean? Let's break it all down.

    An externality occurs when an economic agent only looks at the direct costs and benefits of a decision without considering the indirect costs and benefits (Look at Figure 1). Look at the following example.

    Figure 1. Market inefficiency: externalities - StudySmarter

    An externality is the effect of producing or consuming a good that is felt by a third party.

    A coal mining company uses a method that costs $5 to mine coal. This method of mining coal produces 1 bag of coal but pollutes one gallon of air for the whole community, which includes those who neither produce nor consume the coal.

    In the example, air pollution is an indirect cost that is not being considered by the company. To account for air pollution, the company has to use an alternative method that costs $10 with no air pollution. If the company does this, it has internalized the costs. In other words, the whole community is not paying some of the costs resulting from the polluted air as with the $5 method.

    This is how social efficiency is achieved. It is achieved when all the internal and external costs and benefits have been accounted for.

    Social efficiency refers to a situation where the internal and external costs are equal to the internal and external benefits.

    Social efficiency can also be described as the optimal distribution of resources.

    The Forms of Market Inefficiency

    There are three main forms of market inefficiency. These are allocative, productive, and informational inefficiency.

    1. Allocative inefficiency - Here, the marginal cost of a product does not equal its price.
    2. Productive inefficiency - Consider two products that can be produced at a quantity of 10 each. However, when the quantity of one is increased to 11, only 8 of the other product can be produced. If 11 of one product is made, this results in productive inefficiency.
    3. Informational inefficiency - Here, one side of the market (either the demand or supply side) has more information than the other. For instance, if a seller sells a $5 product for $6 to an unsuspecting customer, this is informational inefficiency as the benefit to the customer has not been maximized.

    Market Inefficiency Diagram

    Market inefficiency refers to a situation where the transactions in a market are not mutually beneficial and the market fails to achieve the optimal outcome. When this happens, there is deadweight loss, which refers to the loss of total surplus as the marginal costs do not equal the marginal benefits. Figure 2 shows the market inefficiency diagram.

    Deadweight loss refers to the loss of total surplus, or consumer and producer benefits, as the marginal costs do not equal the marginal benefits in an inefficient market.

    Market Inefficiency in a Perfectly Competitive Market studysmarterFigure 2. Market Inefficiency in a Perfectly Competitive Market, StudySmarter Originals

    Market Inefficiency Monopoly

    Unlike perfect competition, a monopoly does not lead to mutually beneficial outcomes for both suppliers and consumers. This is because in a monopoly, a firm can focus only on the private benefits without taking externalities into consideration. Here, the firm can raise the price of its product to a point where its surplus exceeds the consumer surplus. When this happens, economists say that the firm is exercising market power. However, in perfect competition, both the consumers and producers play a part in determining the prices. Look at the following example.

    In a town, there are 100 sellers of hats. The buyers of these hats will only buy the hats at the lowest price offered. The hat sellers, wanting to sell their hats quickly, will lower the prices of their hats, and consumer surplus (the benefit of the consumer) will rise.

    In the same town, imagine there is only one seller of hats. The buyers have no choice but to buy from this one seller. This represents a monopoly, and the consumer surplus will decrease as the seller sells hats at a high price.

    A monopoly is a market in which a single producer has absolute control over a good with no substitute and is the only seller.

    Figure 3 shows market inefficiency in a monopoly.

    market inefficiency Monopoly Market Inefficiency studysmarterFigure 3. Monopoly Market Inefficiency, StudySmarter Originals

    Causes of Market Inefficiency

    Market inefficiency occurs in imperfectly competitive markets, but what are some of the underlying causes of market inefficiency? Let's list and explain some of them.

    1. Positive and negative externalities - An externality is the effect of producing or consuming a given good that is felt by a third party. The positive ones affect others positively whereas the negative ones affect others negatively. For example, as a car owner buys and drives a car, the emissions pollute the environment for everybody else, and this is a negative externality. However, as a student receives an education and becomes a doctor, this student provides healthcare for the community, making it a positive externality.
    2. Free riding - This involves the use of public resources by others who did not contribute to its provision. Here, there is little incentive for public goods to be produced since everybody wants to wait for others to produce them.
    3. Monopoly - Here, only one seller of a good without a substitute controls prices by increasing them to a point where consumers buy less and less. In the end, the producer produces below optimal levels and the consumers buy below optimal levels.
    4. Information asymmetry - This happens when one side of the market has more information than the other side. For instance, if a seller knows a sealed box labeled 1 pound contains less than 1 pound but sells it for the price of 1 pound, the consumer surplus is less than it should be, creating a market inefficiency.

    This list covers the fundamentals and is not exhaustive of all possible causes. Once you access a market relationship and realize there is a mismatch between cost and benefit, there is a market inefficiency.

    Market Inefficiency Examples

    There are many real-world market inefficiency examples. Some of these are Microsoft (Windows), Apple Inc. (IOS), and utility firms among others. All these entities provide products with no direct substitutes, which gives them a great deal of control in the market.

    Market Inefficiency - Key Takeaways

    • Market inefficiency refers to a situation where the transactions in a market are not mutually beneficial and the market fails to achieve the optimal outcome.
    • The optimal outcome is the outcome in which the benefits match the cost. The optimal quantity of a product is the quantity where the marginal benefit of consuming one more unit is equal to the marginal cost of producing that unit.
    • An externality is the effect of producing or consuming a good that is felt by a third party.
    • There are three main forms of market inefficiency. These are allocative, productive, and informational inefficiency.
    • Deadweight loss refers to the loss of total surplus, or consumer and producer benefits, as the marginal costs do not equal the marginal benefits in an inefficient market.
    Frequently Asked Questions about Market Inefficiency

    What are the causes of market inefficiency?

    Causes of market inefficiency include positive and negative externalities, free riding, monopoly, and information asymmetry.

    What is market inefficiency?

    Market inefficiency refers to a situation where the transactions in a market are not mutually beneficial and the market fails to achieve the optimal outcome. 

    How do you identify market inefficiencies?

    Market inefficiencies are identified by situations where the benefits don't equal the costs or the optimal outcome has not been achieved.

    What are the 3 forms of market inefficiency?

    The 3 forms of market inefficiency are allocative, productive, and informational inefficiency.

    What are examples of market inefficiency?

    Examples of market inefficiency include Microsoft (Windows), Apple Inc. (IOS), and utility firms.

    Test your knowledge with multiple choice flashcards

    The optimal outcome is the outcome in which the benefits do not match the cost.

    The optimal quantity of a product is the quantity where the marginal benefit of consuming one more unit is equal to the marginal cost of producing that unit.

    The total economic surplus is not maximized when the benefits fully account for the costs.

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    Team Market Inefficiency Teachers

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