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The American Dream and Allocative Efficiency
We depend heavily on a vigorous free market system of competitive markets, but that system simply will not work without proper regulation and augmentation by government. To understand government’s crucial role we need to understand the free market’s strengths and shortcomings.
When the mixed system of free competitive markets is augmented by appropriate regulation and resource allocation by government, we attain what economists term, “allocative efficiency.”
The free market model assumes that the system is populated only with perfectly competitive markets. Firms respond perfectly to the desires of consumers. When tastes change, resource allocation responds immediately. Resources are directed to their most profitable use. They produce an array of outputs that give consumers the most satisfaction possible. Thus, the word “allocative” refers to the allocation of resources so as to maximize our well-being. At the same time, “efficiency” refers to the power of competition to encourage firms to produce at the lowest cost possible.
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Of course our actual economy is somewhat less than perfect. Our government needs to regulate and augment the economy in several ways if we are to attain allocative efficiency. One of our government’s responsibilities is to encourage competition in free markets where possible; but where competition is not possible, the market cannot provide goods widely enough. We then rely on the public sector to intervene in various ways so that we approximate allocative efficiency. Thus, we term ours a “mixed economy.”
Where our democratic government cannot nor will not aid our economic system in attaining allocative efficiency, we term the result a “government failure.” Obviously, our political system does not always measure up to the ideal inherent in our American Dream.
Market Failures
There are several different ways our markets may depart from the ideal. Thus there are several ways government must respond. These “market failures” include: (1) pure public goods, (2) goods with both private and social benefits, (3) markets with imperfect competition (i.e., monopolies and oligopolies), (4) asymmetric availability of technical information, and (5) imperfect or unfair distribution of income. Finally our mixed economic system may experience (6) a system-wide macroeconomic failure such as our current Great Recession. Each of these difficulties requires a different sort of government intervention.
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