Allocative Efficiency vs. Social welfare

If perfect competition always leads to allocative efficiency, does it also lead to increased social welfare? If so, why does the government intervene in the markets in the first place and why does it have monopolies of its own?

By Anupam Manur (@anupammanur)

Source: Cox and Forkum

Source: Cox and Forkum

Perfect competition, by definition, will produce the truest price of goods and services. Due to existence of a large number of buyers and sellers and the competition among them, the market forces of demand and supply alone will determine the price levels in the economy. And it is through the price mechanism that resources are allocated most efficiently: all those who are willing to produce and sell at a given price point and all those who are willing to buy the goods at the given price point can do so.

One of the reasons that governments intervene is to increase competition in the economy. Remember, perfect competition in reality is a rarity. Very few instances of markets that can be described as being perfectly competitive. Competition in the markets can be seen on a continuum with perfect competition at one end and pure monopoly at the other, both of which are ideal types. In reality, most markets fall somewhere in between and it should be the collective effort of society (including government) to push markets towards greater competition. Many government interventions can actually be seen in this light. Liberalising reforms undertaken by the government are usually made with the intention to reduce concentration of market power and increase competition. Privatisation of certain sectors or allowing FDI limits are examples of such reforms. It should be noted that the reason for the concentration of market power could be the government itself. In India, we have seen how the MRTP Act, FERA, etc heavily distorted the markets, which were then reformed in 1991.

Government intervention in markets in the form of actually producing goods and services should be carefully analysed. In some cases, the government can enter a market as one player to provide competition. When it is just one player in the market, it can act as a balancing force to the private player and thereby, increase efficiency due to the added competition (provided, it is a fair market player). The existence of BSNL in the telecom sector is perhaps the best example for this. However, many other instances in history have proved the opposite: that government owned public sector units usually lead to distortions in the economy. Examples range from when the government is the only player (eg. electricity distribution companies) or when the government is part of many players, but fail to produce efficiently (Air India). Bank nationalisation is one of the better examples of how government intervention has resulted in considerable inefficiencies. The reasons for nationalisation was to have greater control over this sensitive sector, to force banks to lend to priority sectors and to the government.

The government can also intervene in markets to correct other forms of market imperfections. Apart from concentration of market power discussed above, market imperfections can take other forms: under production of public goods and merit goods (goods with positive externalities), overproduction of demerit goods, etc. Government intervention in these aspects can lead to higher social welfare.

While these interventions tend to increase economic efficiency, other interventions will be detrimental to it.  When the government intervenes in the market in order to meet its social objectives or for certain political reasons, it will lead to a reduction in economic efficiency and even reduces social welfare in the long run. These interventions are undertaken when the government believes that the economically efficient outcomes may not lead to social welfare or that the aggregate social welfare might not accrue proportionately to targeted sections of society. For example, imagine if the railways were completely privatised, then, at equilibrium, the tickets would shoot up by 4-5 times at least and this could make it unaffordable to the poor. This prompts the government to run the Indian railways itself, such that it can have better control over the price mechanism.

When the government uses the price mechanism to achieve political and social objectives, it will lead to a reduction in economic efficiency. High ‘sin taxes’ are used in order to curb activities such as smoking and drinking. Taxes are also used as a tool for redistribution of wealth: high tax on ‘luxury’ items in order to fund welfare schemes.

The gray areas in government intervention occurs when there is a clash between economic efficiency and social welfare. Sometimes, economically efficient outcomes may lead to a reduction of social welfare. Imagine the market for essential drugs. An economically efficient solution might price a life-saving drug too high and out of reach of most citizens, thereby reducing social welfare. Else, imagine if there is a sudden drought this year with the failure of monsoons and the prices of essential commodities soar. The markets might not price in the extreme consequences of such events, which might even be death. In each of these cases, it might be justifiable for the government to intervene. The challenge is to find the least distortionary method to do so.

Anupam Manur is a Policy Analyst at the Takshashila Institution.