14.20 : First Welfare Theorem II

Markets don’t always work perfectly. In theory, they should allocate resources efficiently, but real-world problems often get in the way. One major issue is externalities—when a transaction affects people who aren’t directly involved. Negative externalities, like pollution, impose costs on others without compensation. A steel factory dumping waste into a river harms nearby farmers, yet the factory has no reason to stop unless regulations or taxes force it to consider these hidden costs.

Another challenge is asymmetric information. When one party knows more than the other, markets become inefficient. If a landlord hides plumbing problems from a tenant, the tenant might pay more than the apartment is worth. This imbalance can lead to adverse selection, where only lower-quality products remain in the market, or moral hazard, where people take bigger risks because they don’t bear the full consequences. Transparency laws and disclosure rules help correct this.

People also don’t always make rational economic decisions. Standard economic theory assumes they do, but in reality, emotions and biases influence behavior. Panic buying during a health scare can lead to shortages and price spikes, disrupting the market. Policymakers often use nudges and public information campaigns to prevent these inefficiencies.

Some markets are incomplete, meaning they don’t provide ways to trade certain goods or manage risks. Without proper insurance, small businesses may avoid investing, slowing economic growth. Governments step in with subsidies or financial tools to fill these gaps. Without intervention, markets often fail to reach efficiency on their own.