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A central precept in economics is that prices set in perfectly competitive markets provide clear signals of the value the economy places on items. In a competitive market, the value to a consumer of the last pizza sold should equal the value of the resources used in its production. An economic distortion occurs when some market intervention creates a wedge between the value of resources used in the production of that pizza and the value to consumers of consuming it. In the presence of distortions, opportunities exist to make someone better off without making anyone else worse off. This is known as a Pareto improvement.
Distortions arise for several reasons. First, companies may erect entry barriers, thereby creating market power. A monopoly is an extreme example of such market power. Firms with market power can sell goods at a price exceeding their marginal cost of production.
Second, the production or consumption of some commodity may have some positive or negative impact on other parts of the economy not transmitted through market prices. Such impacts are called externalities. A coalfired electric utility emitting sulfur dioxide as a by-product of electricity generation creates a negative externality. In general, an unregulated economy produces too many goods with negative externalities and too few goods with positive externalities.
Third, buyers and sellers in a market may have asymmetric information about the good in question. Used-car markets are a good example. Sellers have better information about the quality of their car than do buyers. Since buyers will logically assume that owners of high-quality cars will tend to hold on to them while owners of lowquality cars will tend to sell them, a large share of the cars in the used-car market will be low-quality. Thus buyers will lower their bid for a used car. This will lead to fewer high-quality cars being sold. In the limit, this can lead to a collapse of the market, leaving both buyers and sellers worse off. This is an example of adverse selection, where the pool of items offered in a market are not representative of the typical items in existence.
Finally, government policies, intentionally or unintentionally, may create distortions. Most governments rely on income or consumption taxes to raise revenue for important government programs. Income taxes distort labor supply and savings decisions, while consumption taxes distort labor supply and consumption decisions.
Whether governments should intervene to correct distortions depends on a number of factors. Taxes on pollution set equal to the social marginal damages of pollution, for example, are generally viewed by economists as welfare enhancing. Many countries regulate monopolies or actively intervene in markets to promote competition. It may be, however, that in some cases interventions create more harm than good, in which case it may be preferable to live with the distortion. In other cases, distortions may be a necessary by-product of a desired social aim. Any redistribution through the tax system, for example, will create some degree of distortion, thereby illustrating the classic trade-off between efficiency and equity.
When facing multiple distortions, no clear prescription exists for the optimal ordering of eliminating distortions. Moreover, the first-best prescription for a given distortion may no longer hold in the presence of distortions elsewhere in the economy. This is the classic problem of the second best identified by Richard G. Lipsey and Kelvin Lancaster (1956–1957). Environmental policy provides an example of this phenomenon. In the absence of any other distortions, a first-best solution to the presence of pollution is to set a tax on pollution equal to social marginal damages. When taxes create distortions in capital and labor markets, however, this first-best prescription no longer holds. Instead, the optimal tax on pollution in most circumstances falls short of social marginal damages.
- Auerbach, Alan, and James Hines. 2002. Handbook of Public Economics, Vol. 3: Taxation and Economic Efficiency. Amsterdam: North-Holland.
- Fullerton, Don, and Gilbert E. Metcalf. 1998. Environmental Taxes and the Double-Dividend Hypothesis: Did You Really Expect Something for Nothing? Chicago-Kent Law Review 73 (1): 221–256.
- Lipsey, Richard G., and Kelvin Lancaster. 1956–1957. The General Theory of Second Best. Review of Economic Studies 24 (1): 11–32.
- Rosen, Harvey S. 2004. Public Finance. 7th ed. New York: McGraw-Hill/Irwin.
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