Allocative Efficiency and Market Failure
We have seen that perfect competition is allocatively efficient and that
monopoly and other forms of imperfect competition are not. Most of the
remainder of this chapter presents ways in which public policy has
attempted to deal with problems raised by the inefficiency of imperfect
competition. Before we go on, however, it is important to re-emphasize
that perfect competition exists in a small number of industries, is only
approximated in some others, and is not even closely resembled in many.
Hence, to say that perfect competition is allocatively efficient is not to say
that real-world market economies are ever allocatively efficient.
In Chapter 16 , we discuss the most important ways (other than
imperfect competition) in which market economies may fail to produce
efficient outcomes. In Chapters 17 and 18 , we discuss and evaluate the
most important public policies that have been used to try to correct for
these market failures. One of the most important problems arises when
market transactions—production or consumption or both—impose costs
or confer benefits on economic agents who are not involved in the
transaction. Cases like these, which are called externalities because they
involve economic costs or benefits for parties that are “external” to the
transaction, generally raise the possibility that market outcomes will be
allocatively inefficient.