equilibrium price is still 5, but for some reason, the current price on the market is only $4. At that price, the suppliers are only willing to provide 1,000 hamburgers, but the buyers want to purchase 2,000 leading to a hamburger shortage. Out of the 2,000 units in demand, buyers are only able to purchase half that amount.
Figure 7 Disequilibrium in Marketville.
In the short run, non-market rationing solutions spring up nearly immediately. People will queue up for hamburgers, and those who arrive early will be able to buy the product, while latecomers will not. Eventually, sellers will realize that they are able to charge more. They will raise the price to $5, hire more employees to expand their production, and maybe even open new restaurants, increasing the total supply of hamburgers to 1,500. Seeing the price increase, consumers could decide to eat something else—or still purchase hamburgers, but eat less of them.9 This reduction of the quantity demanded to 1,500 hamburgers means that all consumers will get to have a hamburger, which might eliminate the lengthy queuing for it.
When the price is higher than the equilibrium price, similar mechanisms can be seen. In that case, the quantity supplied exceeds quantity demanded, leading to surplus production (or as economists euphemistically call it, unintended inventory investment). In practice, this means that sellers can’t get rid of their stock (or in case of the hamburger example, only a few consumers come in to eat them). Seeing the products pile up (or the dearth of consumers), producers will organize a “sale”—which is literally a reduction of price, potentially moving the market towards equilibrium.
Market Efficiency and Failures
A perfectly competitive market achieves two kinds of efficiencies: distributive efficiency and allocative efficiency. Distributive efficiency is an effect of goods and services being received by those with the greatest need, if need is defined as willingness to pay the most for a product.10 The market mechanism ensures that everyone whose reservation price is greater or equal than the market price will be able to buy the product, while those whose reservation price is below the market price will not be able to do so. This also ensures that all the sellers combined can extract the highest total amount of payments from the buyers.
Allocative efficiency exists when the goods and services produced in the economy match consumer preferences. This occurs when the unit produced provides a marginal benefit to consumers equal to the marginal cost of production. Companies that use fewer resources (thus using the resources more efficiently) will be able to offer their products (and turn a profit) at lower prices.11 The market mechanism ensures that every single firm that is profitable at a price below market price will produce goods, while those firms that require higher prices in order to be profitable will instead produce something else.
Market Failures
A market failure occurs when the allocation of goods and services is not efficient in the manner described above. There are two kinds of market failure in law: 1) those which the courts regulate and 2) those which the courts leave to market participants to resolve.
A competitive market requires many buyers who purchase relatively small quantities compared to the quantity demanded. There are many sellers who all produce relatively small amounts of the good compared to the quantity demanded. There is no way to distinguish between goods of the sellers. Courts generally do not regulate markets to add buyers or sellers or to standardize goods.12
A market failure can occur when participants are either unaware of their self-interest or act contrary to it. Again, courts are hesitant to question to the motives of market participants.13 Market efficiency assumes that market participants have perfect information in that all material information about their products is known. Courts are willing to step in on this point in both contracts for services and contracts for the sale of goods as noted in Chapters 4 and 5.
Transaction Costs
Transaction costs are all the costs associated with the purchase that have to do with making sure the purchase actually happens. Legal fees associated with lawsuits are the transaction cost most commonly discussed in this volume. Searching costs involved in finding the right employee are explored in Chapter 7.
An additional cost is information gathering. In the age of the Internet, an overabundance of information makes it hard to determine what is reliable, creating additional transaction costs for information validation efforts.
Bargaining is a transaction cost in the process of coming up with the actual details of a given transaction. Bargaining involves the process of finding terms (usually those other than price and quantity) that are necessary in order to close the deal. Some terms worth bargaining for are described in more detail in Chapters 4–6.
Enforcement costs include all the costs related to making sure that the other party upholds the terms of the deal struck. These costs can vary greatly depending on the governing legal system in the country. Companies in common law nations tend to employ a larger number of lawyers than companies in civil law countries, as the built-in structure of the legal system allows more room for interpretation, thus making more work for the legal professionals. This means that the common law systems inherently tend to incur higher transaction costs than civil law systems.
Externalities
An externality is a cost that is put on a third party to a transaction that is neither the buyer nor the seller. Positive externalities cause a benefit to a third party, while negative externalities cause a cost to a third party. Consumer externalities occur as a result of a consuming behavior, while producer externality is a result of production.
The economic problem with externalities is that the additional costs and benefits occur to third parties, so on their own, decision makers frequently ignore them. This means that in case of a negative externality, the private cost of production or consumption is lower than the social cost. Negative externalities lead to overproduction or overconsumption, as part of the cost is borne by others.
In case of a positive externality, the private benefit of the production or consumption is lower than the social benefit. For example, when one decides to vaccinate their child, they consider the fact that their child has a lowered risk of infection—and ignore the positive externality of increased protection that vaccination conveys to other children. Positive externalities lead to underproduction or underconsumption, as part of the benefit is realized by others.
Externalities distort the market mechanism, eliminating the surety that markets guarantee efficient production and consumption. Because externalities lead to overconsumption, underconsumption, overproduction, or underproduction, it is beneficial from the standpoint of a society to try to mitigate or eliminate the effects of externalities. This is called internalizing the externalities.
From about 1930 to the end of World War II, courts aggressively put the costs of externalities onto the party receiving the benefit. A cost-benefit analysis became popular after that which asked whether society was better off with the third party bearing the externality. Chapter 3 explains this in detail.
Public Goods
A
