Imperfections and Distortions Defined

9.2 Imperfections and Distortions Defined

Learning Objectives

Identify the various types of market imperfections and distortions.
Recognize that market imperfections and distortions are widespread in real-world markets.

Market imperfections and distortions, generally, are any deviations from the assumptions of perfect competition. Many of the assumptions in a perfectly competitive model are implicit rather than explicit—that is, they are not always stated.

Below are descriptions of many different types of imperfections and distortions. Perfect competition models assume the absence of these items.

Monopoly, Duopoly, and Oligopoly

Perhaps the most straightforward deviation from perfect competition occurs when there are a relatively small number of firms operating in an industry. At the extreme, one firm produces for the entire market, in which case the firm is referred to as a monopoly. A monopoly has the ability to affect both its output and the price that prevails on the market. A duopoly consists of two firms operating in a market. An oligopoly represents more than two firms in a market but less than the many, many firms assumed in a perfectly competitive market. The key distinction between an oligopoly and perfect competition is that oligopoly firms have some degree of influence over the price that prevails in the market.

Another key feature of these imperfectly competitive markets is that the firms within them make positive economic profits. The profits, however, are not sufficient to encourage entry of new firms into the market. In other words, free entry in response to profit is not possible. The typical method of justifying this is by assuming that there are relatively high fixed costs. High fixed costs, in turn, imply increasing returns to scale. Thus most monopoly and oligopoly models assume some form of imperfect competition.

Large Countries in International Trade

Surprisingly, “large” importing countries and “large” exporting countries have a market imperfection present. This imperfection is more easily understood if we use the synonymous terms for “largeness,” monopsony and monopoly power. Large importing countries are said to have “monopsony power in tradeAnother term to describe a large importing country—that is, a country whose policy actions can affect international prices.,” while large exporting countries are said to have “monopoly power in tradeAnother term to describe a large exporting country—that is, a country whose policy actions can affect international prices..” Let’s first consider monopoly power.

When a large exporting country implements a trade policy, it will affect the world market price for the good. That is the fundamental implication of largeness. For example, if a country imposes an export tax, the world market price will rise because the exporter will supply less. An export tax set optimally will cause an increase in national welfare due to the presence of a positive terms of trade effect. This effect is analogous to that of a monopolist operating in its own market. A monopolist can raise its profit (i.e., its firm’s welfare) by restricting supply to the market and raising the price it charges its consumers. In much the same way, a large exporting country can restrict its supply to international markets with an export tax, force the international price up, and create benefits for itself with the terms of trade gain. The term monopoly “power” is used because the country is not a pure monopoly in international markets. There may be other countries exporting the product as well. Nonetheless, because its exports are a sufficiently large share of the world market, the country can use its trade policy in a way that mimics the effects caused by a pure monopoly, albeit to a lesser degree. Hence the country is not a monopolist in the world market but has “monopoly power” instead.

Similarly, when a country is a large importer of a good, we say that it has “monopsony power.” A monopsony represents a case in which there is a single buyer in a market where there are many sellers. A monopsony raises its own welfare or utility by restricting its demand for the product and thereby forcing the sellers to lower their price. By buying fewer units at a lower price, the monopsony becomes better off. In much the same way, when a large importing country places a tariff on imports, the country’s demand for that product on world markets falls, which in turn lowers the world market price. An import tariff set optimally will raise national welfare due to the positive terms of trade effect. The effects in these two situations are analogous. We say that the country has monopsony “power” because the country may not be the only importer of the product in international markets, yet because of its large size, it has “power” like a pure monopsony.

Externalities

ExternalitiesEconomic actions that have effects external to the market in which the action is taken. are economic actions that have effects external to the market in which the action is taken. Externalities can arise from production processes (production externalities) or from consumption activities (consumption externalities). The external effects can be beneficial to others (positive externalities) or detrimental to others (negative externalities). Typically, because the external effects impact someone other than the producer or consumers, the producer and the consumers do not take the effects into account when they make their production or consumption decisions. We shall consider each type in turn.

Positive Production Externalities

Positive production externalities occur when production has a beneficial effect in other markets in the economy. Most examples of positive production externalities incorporate some type of learning effect.

For example, manufacturing production is sometimes considered to have positive spillover effects, especially for countries that are not highly industrialized. By working in a factory, the production workers and managers all learn what it takes to operate the factory successfully. These skills develop and grow over time, a process sometimes referred to as learning by doing. The skills acquired by the workers, however, are likely to spill over to others in the rest of the economy. Why? Because workers will talk about their experiences with other family members and friends. Factory managers may teach others their skills at local vocational schools. Some workers will leave to take jobs at other factories, carrying with them the skills that they acquired at the first factory. In essence, learning spillovers are analogous to infectious diseases. Workers who acquire skills in one factory in turn will infect other workers they come into contact with and will spread the skill disease through the economy.

A similar story is told concerning research and development (R&D). When a firm does R&D, its researchers learn valuable things about production that in turn are transmitted through the rest of the economy and have positive impacts on other products or production processes.

Negative Production Externalities

Negative production externalities occur when production has a detrimental effect in other markets in the economy. The negative effects could be felt by other firms or by consumers. The most common example of negative production externalities involves pollution or other environmental effects.

When a factory emits smoke into the air, the pollution will reduce the well-being of all the individuals who must breathe the polluted air. The polluted air will also likely require more frequent cleaning by businesses and households, raising the cost incurred by them.

Water pollution would have similar effects. A polluted river cannot be used for recreational swimming or at least reduces swimmers’ pleasures as the pollution rises. The pollution can also eliminate species of flora and fauna and change the entire ecosystem.

Positive Consumption Externalities

Positive consumption externalities occur when consumption has a beneficial effect in other markets in the economy. Most examples of positive consumption externalities involve some type of aesthetic effect.

Thus when homeowners landscape their properties and plant beautiful gardens, it benefits not only themselves but also neighbors and passersby. In fact, an aesthetically pleasant neighborhood where yards are neatly kept and homes are well maintained would generally raise the property values of all houses in the neighborhood.

One could also argue that a healthy lifestyle has positive external effects on others by reducing societal costs. A healthier person would reduce the likelihood of expensive medical treatment and lower the cost of insurance premiums or the liability of the government in state-funded health care programs.

Negative Consumption Externalities

Negative production externalities occur when consumption has a detrimental effect in other markets in the economy. Most examples of negative consumption externalities involve some type of dangerous behavior.

Thus a mountain climber in a national park runs the risk of ending up in a precarious situation. Sometimes climbers become stranded due to storms or avalanches. This usually leads to expensive rescue efforts, the cost of which is generally borne by the government and hence the taxpayers.

A drunk driver places other drivers at increased risk. In the worst outcome, the drunk driver causes the death of another. A smoker may also put others at risk if secondhand smoke causes negative health effects. At the minimum, cigarette smoke surely bothers nonsmokers when smoking occurs in public enclosed areas.

Public Goods

Public goodsGoods that are nonrival (the consumption or use of a good by one consumer does not diminish the usefulness of the good to another) and nonexcludable (once the good is provided, it is exceedingly costly to exclude nonpaying customers from using it). have two defining characteristics: nonrivalry and nonexcludability. NonrivalryA situation in which consumption or use of a good by one consumer does not diminish the usefulness of the good to another. means that the consumption or use of a good by one consumer does not diminish the usefulness of the good to another. NonexcludabilityA situation in which once the good is provided, it is exceedingly costly to exclude nonpaying customers from using it. means that once the good is provided, it is exceedingly costly to exclude nonpaying customers from using it. The main problem posed by public goods is the difficulty of getting people to pay for them in a free market.

The classic example of a public good is a lighthouse perched on a rocky shoreline. The lighthouse sends a beacon of light outward for miles, warning every passing ship of the danger nearby. Since two ships passing are equally warned of the risk, the lighthouse is nonrival. Since it would be impossible to provide the lighthouse services only to those passing ships that paid for the service, the lighthouse is nonexcludable.

The other classic example of a public good is national security or national defense. The armed services provide security benefits to everyone who lives within the borders of a country. Also, once provided, it is difficult to exclude nonpayers.

Information has public good characteristics as well. Indeed, this is one reason for the slow start of electronic information services on the World Wide Web. Once information is placed on a Web site, it can be accessed and used by millions of consumers almost simultaneously. Thus it is nonrival. Also, it can be difficult, although not impossible, to exclude nonpaying customers from accessing the services.

Nonclearing Markets

A standard assumption in general equilibrium models is that markets always clear—that is, supply equals demand at the equilibrium. In actuality, however, markets do not always clear. When markets do not clear, for whatever reason, the market is distorted.

The most obvious case of a nonclearing market occurs when there is unemployment in the labor market. Unemployment could arise if there is price stickiness in the downward direction, as when firms are reluctant to lower their wages in the face of restricted demand. Alternatively, unemployment may arise because of costly adjustment when some industries expand while others contract. As described in the immobile factor model, many factors would not immediately find alternative employment after being laid off from a contracting industry. In the interim, the factors must search for alternative opportunities, may need to relocate to another geographical location, or may need to be retrained. During this phase, the factors remain unemployed.

Imperfect Information

One key assumption often made in perfectly competitive models is that agents have perfect information. If some of the participants in the economy do not have full and complete information in order to make decisions, then the market is distorted.

For example, suppose entrepreneurs did not know that firms in an industry were making positive economic profits. Without this information, new firms would not open to force economic profit to zero in the industry. As such, imperfect information can create a distortion in the market.

Policy-Imposed Distortions

Another type of distortion occurs when government policies are set in markets that are perfectly competitive and exhibit no other distortions or imperfections. These were labeled policy-imposed distortions by Jagdish Bhagwati since they do not arise naturally but rather via legislation.

Thus suppose the government of a small country sets a trade policy, such as a tariff on imports. In this case, the equilibrium that arises with the tariff in place is a distorted equilibrium.

Key Takeaways

An implicit assumption of perfect competition models is that there are no market imperfections or distortions in place.
Among some of the most common market imperfections are monopolies, oligopolies, large countries in trade, externalities, public goods, nonclearing markets, imperfect information, and government tax and subsidy policies.
Externality effects can arise from production or consumption activities.
Externalities can be positive or negative in their effects.

Exercise

Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
1. The term used to describe the favorable effect that a production activity can have in another market.
2. The term used to describe the detrimental effect that a consumption activity can have on another person.
3. The two characteristics that identify “public goods.”
4. The term used to describe the type of distortion that occurs when governments implement taxes, subsidies, or regulations in otherwise perfectly competitive markets.
5. The type of power a large importing country is said to have.
6. The type of power a large exporting country is said to have.