Market Efficiency 303at least cost.In short, a system of competitive markets in which all goods and serv-
ices and all inputs (including labor) can be freely bought and sold provides a
solution to the economic problem of resource allocation.^13 Indeed, no matter
how well intentioned, government measures that interfere with competitive
markets can cause welfare losses.
A final virtue of competitive markets is that they are dynamically efficient;
that is, they respond optimally to changes in economic conditions. If a new
product or service can be supplied at a cost below the price consumers are will-
ing to pay, profit-seeking firms will create and supply a market where none for-
merly existed. If demand for an existing product rises, so will price, thus
attracting new entrants and further supply. At the new equilibrium, the effi-
ciency condition, P MB MC, will be restored. Alternatively, if costs decline,
the efficient response is achieved via a fall in price, causing consumption to
increase to a new, optimal level. Finally, markets encourage the pursuit of tech-
nological innovations. Firms have a continuous incentive to search for and
adopt more profitable methods of production.
The “invisible hand” theorem—that perfectly competitive markets ensure
maximum social benefits—is best thought of as a benchmark. Although many
markets in the United States meet the requirements of perfect competition,
notable cases of market failures also exist. Market failures usually can be traced
to one of three causes: (1) the presence of monopoly power, (2) the existence
of externalities, or (3) the absence of perfect information. In Chapter 11, we
analyze each of these sources of market failure.(^13) The proof of the “efficiency theorem” is beyond the scope of this book. It can be shown that a
perfectly competitive economy is Pareto efficient;that is, it is impossible to reorganize the economy
to make some economic agent (an individual or a firm) better off without making some other
agent worse off.
(^14) For interesting discussions of market competition and the Internet, see J. D. Levin, “The Economics
of Internet Markets.” National Bureau of Economic Research, Working Paper 16852, March 2011; G. Ellison
and S. F. Ellison, “Lessons about Markets from the Internet,” Journal of Economic Perspectives(Spring
2005): 139–158; “A Perfect Market: Survey of E-commerce,” The Economist(May 15, 2004), special sup-
plement; E. Brynjolfsson, Y. Hu, and M. D. Smith, “Consumer Surplus in the Digital Economy:
Estimating the Value of Increased Product Variety at Online Booksellers,” Management Science
(November 2003): 1580–1596; M. E. Porter, “Strategy and the Internet,” Harvard Business Review
(March 2001): 63–78; S. Borenstein and G. Saloner, “Economics and Electronic Commerce,” Journal
of Economic Perspectives(Winter 2001): 3–12; and R. E. Litan and A. M. Rivlin, “Projecting the Economic
Impact of the Internet,” American Economic Review, Papers and Proceedings (May 2001): 313–317.
Is competition on the Internet one further step toward the textbook case of
perfect competition?^14 The affirmative view holds that Internet competition,
where consumers can easily find and identify the cheapest prices, should
squeeze prices and profit margins to the bone. The early evidence suggests that
the Internet can promote competition and efficiency in several respects. First,
transacting online provides buyers and sellers much better information about
available prices for competing goods. Clearly, the ability of customers to find
better prices for standardized goods increases competition and induces more
Market
Competition
and the Internet
c07PerfectCompetition.qxd 9/29/11 1:30 PM Page 303