We now set aside, for the time being, the reasons for market failure and proceed with our investigation of the case for competitive markets.
We have shown that, with reasons for market failure absent, a competitive market equilibrium is efficient. However, we have not shown that market deci-sions are the only means of achieving efficiency. An alternative to a market is a government agency that replaces decentralized market decisions of buyers and sellers with centralized decisions made on behalf of the population. When a gov-ernment agency makes centralized decisions, the economic freedom to make per-sonal voluntary market decisions has been lost. With economic freedom forgone, can a centralized government agency nonetheless replicate the efficiency of a market that the agency has replaced? A case based on information suggests that a government agency making centralized decisions cannot achieve the efficiency of the personal, decentralized decisions of a competitive market.
Information
Markets aggregate information. The aggregated information is the sum of the dis-persed information that is revealed when individual buyers and sellers make per-sonal market decisions. The aggregated information is expressed in the market demand and supply functions that determine market prices. With market prices determined and observable, people need to know only their own MBs as buy-ers or own MCs as sellbuy-ers to make the pbuy-ersonal decisions that result in market efficiency.
Efficiency through decentralized market choice is demonstrated in figure 1.8a, which shows a given quantity of output QBand the willingness to pay expressed in MB of two buyers. MB1is measured from the O1origin and MB2from the O2
origin. The buyers observe the common buying price PBand they know their own marginal benefits. To maximize utility or personal benefit, each buyer sets the observed market price facing buyers PBequal to personal MB. Total benefit of the two buyers B= (B1+ B2) is maximized by individual decentralized decisions that result in:
MB1= PB= MB2. (1.19)
O1
Figure 1.8. (a) Information about MB. (b) Information about MC.
The efficient division of QBat point J in figure 1.8a is thus achieved by decentral-ized market decisions, with person 1 voluntarily purchasing the quantity qb1and person 2 voluntarily purchasing the quantity qb2.
To replicate the efficient division of output at point J that results from buy-ers’ voluntary decentralized market decisions, a government agency would need to know the location of the personal marginal benefit functions MB1 and MB2. However, personal MB is private information of buyers. When a government agency seeks to replace a market, we therefore have a case of asymmetric infor-mation. Individuals know their MBs. The government agency does not. Asym-metric information is not a problem for achieving efficiency through market out-comes. The private information about personal MB is revealed spontaneously through personal market decisions when buyers set MB equal to the market price.
Because an individual’s MB is private information, a government agency that has replaced the market could only guess at the efficient division of the quantity QB
in figure 1.8a. For example, a guess by the government agency that efficiency requires an equal division of the quantity QBbetween persons 1 and 2 results in a loss equal to the area GDJ.18
A government agency that sets out to choose efficient supply assignments among producers is at a similar informational disadvantage compared to a com-petitive market. Figure 1.8b shows the marginal costs of two suppliers, with O1 the origin for MC1of supplier 1 and O2the origin for MC2of supplier 2. In a mar-ket, the two suppliers observe the common market selling price PSand maximize profits by setting PSequal to their personal MC. The suppliers know their own marginal costs and choose their respective quantities to supply such that:
MC1= PS= MC2. (1.20)
18 When there is equal division, MB2at point G, exceeds MB1at point D. The gain from moving from equal to efficient division is GDJ.
Efficient supply is thus achieved through decentralized market decisions, with supplier 1 choosing to supply the quantity qs1 and supplier 2 choosing to supply the quantity qs2.
A government agency that has been set the task of replicating the efficient market outcome needs to know suppliers’ marginal costs. Information on costs may be easier to find than the information on marginal benefits because costs may be objectively observable, whereas benefits of buyers are subjective and unobservable. Costs, however, include costs of unobservable effort. If govern-ment agencies also have replaced markets for inputs, costs of inputs have to be computed without the presence of market valuations. Government agencies can-not be expected to know precise marginal costs of different suppliers. A guess by a government agency of equal division of supply assignments results in an effi-ciency loss equal to the area GSJ in figure 1.8b.
Efficient assignment of goods among consumers or users to achieve maxi-mum total benefit Bmax and efficient assignment of supply among suppliers to achieve minimum total cost Cminare two of the three requirements for efficiency.
The third requirement is choice of an efficient quantity QE that maximizes W= (Bmax− Cmin). A government agency that lacks information to achieve Bmax or Cmin cannot, of course, compute W= (Bmax− Cmin). The third requirement for efficiency is then also beyond the information capabilities of the government agency.
A government agency may look diligently for ways to measure personal bene-fits and costs and use procedures that we shall study known as cost-benefit anal-ysis. However, the information that is sought cannot be found if the information does not exist outside of the market that the government agency has replaced – or is seeking to replace.
With markets not in existence to reveal information, the information that a government agency requires to achieve efficiency may not exist to be found.
Political decision makers
Although government agencies are at an informational disadvantage compared to markets, political decision makers may prefer centralized government deci-sions because:
Through centralized decisions, political allocation replaces market allo-cation.
Political allocation provides political decision makers with the means to con-trol the distribution of benefits and costs among a population. Through central-ized decisions, political decision makers can take personal credit for providing benefits to constituencies or political supporters. Political decision makers may also be able to decide on which supplier receives a government contract for
supply and the price of supply may allow for profits that a supplier would not earn in a competitive market.
Ideology and imposed order
A preference for centralized decisions can be due to ideology rather than self-interested political behavior. An ideology associated with the “left” in economics and politics proposes that centralized government decisions avoid the “anarchy”
of markets by imposing “order” on economic activity. The ideology associates market decisions with “anarchy” because of the uncoordinated, decentralized decisions independently made in markets by buyers and sellers. The ideology is therefore in direct contradiction to the invisible hand of Adam Smith according to which markets do not result in anarchy but rather achieve efficiency sponta-neously through the economic freedom to make voluntary personal decisions.
A rudimentary example of spontaneous order is a farmers’ market. Farmers arrive at the market with produce for sale, having independently made supply decisions for the produce that they bring to the market. No centralized direc-tives have been issued about the types of products and the quantities that should be brought to the market. Buyers also arrive at the market to make their pur-chases. At the end of the day, the farmers leave, to return the next day with new supplies. Buyers also return. Spontaneous order is present, with every buyer and seller knowing “what to do” without centralized instructions. Moreover, central-ized instructions could not duplicate the efficiency of the decentralcentral-ized market decisions because the information required for efficiency is not available without the existence of a market in which the information is revealed through the per-sonal decisions of buyers and sellers.
Information and spontaneous order: Normative and positive conclusions
We now have a normative and a positive conclusion about information and spon-taneous order. The normative conclusion extends the prima facie case for the market beyond efficiency and personal freedom:
Markets are informationally efficient.
The positive conclusion is that we cannot predict that markets will necessarily be chosen in preference to centralized decisions of government because:
Political decision makers may prefer centralized decisions.
Ideology may favor centralized decisions.
There is a link:
Political decision makers may prefer an ideology that favors centralized decisions.