Goodwin%20MarketFailureFinal2005%20copy%202 - GLOBAL...

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G LOBAL D EVELOPMENT AND E NVIRONMENT I NSTITUTE The Limitations of Markets: Background Essay Neva Goodwin December 2005 Tufts University Medford MA 02155, USA © Copyright 2005 Global Development and Environment Institute, Tufts University
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The Limitations of Markets: Background Essay Neva Goodwin There are a number of ways in which economic theory affects both the study and the practice of business. Economic theories may be offered to explain how businesses operate; students and teachers of business generally ignore some of the less realistic portions of these explanations, while making use of the more practical aspects. Economic theories are also used as justification for government policies that regulate or otherwise affect business. There is an especially relevant part of economic theory that describes how socially optimal results can come about through perfect markets that allocate resources according to society’s most preferred uses. This theory is important because it is the theoretic underpinning for policies and prescriptions that have significantly shaped the modern world. Recommendations to reduce trade restrictions – to privatize utilities, prisons, or water distribution – to reduce regulations on businesses – and generally to get the government “out of the way” of the free operation of markets – all are supported by the theory of perfect markets. Business leaders and voting citizens as well as policy makers are influenced in their decision-making by the idea that a “perfectly free” market can produce a social optimum (a “best of all possible worlds”). Because this idea is so influential, it is important to understand the conditions that must be met for the theory to work. The theoretic prediction of the optimality of market outcomes presupposes a number of requirements, which can be grouped into three broad categories: (1) the assumption of perfectly functioning markets; (2) market-oriented patterns of motivation and behavior, on the part of both individuals and firms; and (3) the universal existence and scope of markets. This essay will begin with an emphasis on (1). We will then touch briefly on the second and third requirements, and end with (4) a comment on the important issues that are buried in the concept of the “most preferred” uses for resources (referred to, above, in the statement that “socially optimal results can come about through perfect markets that allocate resources according to society’s most preferred uses”). 1) THE ASSUMPTION OF PERFECTLY FUNCTIONING MARKETS The predictions of standard economic theory – the expectation that freely operating markets will produce a certain kind of optimality – only hold good as long as the markets are not marred by serious imperfections. Such imperfections, sometimes referred to as market failures , include situations in which markets are affected by a number of issues. These issues, including public goods, externalities, transaction costs, and market power, will be described below. 1
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Goodwin%20MarketFailureFinal2005%20copy%202 - GLOBAL...

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