Module B Market failures

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B. MARKETS AND FAILURES B.1.1. An overview on the functioning of the market economy Since economic resources are scarce, we need the economic science. Indeed, resources’ scarcity leads to three key issues to be addressed: - What to produce (i.e., what is more convenient to produce from an economic point of view?)→ “one dollar, one vote” mechanism: companies must listen to market’s requests to maximize profits. - How to produce → solved by competition that leads companies to cut costs (i.e., production efficiency, often related to process innovation) and reduce prices. - How to distribute the wealth resulting from production → it depends on the price of inputs (i.e., labor and capital), which, in turn, depends on their availability and quality. In a pure market economy perspective, these decisions are “indirect”: they are naturally “taken” by price mechanisms. Above, each issue is matched by its corresponding “natural” market solution, introduced by "→". On the contrary, in a planned economy, a central decision maker (i.e., government, the state) decides what to produce, how to produce and how to distribute wealth, basing on the idea that economic activities must benefit the whole society . To do so, the central planner needs an enormous amount of information, which, in market economy, are embedded in the price mechanism. However, the planner does not have them, and planned economies fail. In the real world, we have neither pure market economies nor planned economies: current economic systems are shaped by the presence of firms, which want to maximize their profits, and policymakers, which want to maximize social welfare. Indeed, firms are a clear hybrid between pure market economy (i.e., economic activities are fully decentralized and consists of individual…