Unequal distribution of income
Pareto efficiency holds that it is not possible to make one person better-off without making another person worse-off (Case, Fair and Oster, 2009). This means that goods and services in the economy are fully utilized based on the marginal willingness to pay and therefore there is no surplus. Where one person is made better without making another person worse-off, then there arises inefficiency which must be eliminated through Pareto improvement.
In the economy where resources are allocated based on willingness to pay (perfect competition) the welfare of the people is put in question, with those with higher disposable income gaining at expense of those who don’t have. Therefore Pareto efficiency leads to unequal distribution of income and wealth, a situation that calls for government intervention to save the poor.
The government intervention may be through the imposition of progressive income taxation whereby the rich will pay more taxes and the poor will pay less thus bridging the gap on income distribution. Taxation will have an effect on the marginal cost of goods thus reducing the price that the consumers will be willing to pay and the process increase the redistribution of income.
The government also needs to intervene through antipoverty programs such as the provision of public goods such as health services, education, and road network, and so on. Or offer subsidies to private suppliers of public goods. In addition to providing pure public goods such as defense, the government should provide mixed public goods that have non-rivals and excludability (goods that have zero marginal cost) like education and health to prevent exploitation of the poor by the rich.
Imperfect competition
‘Imperfect’ competition may exist in a Pareto efficient market. In this case, there exists market inefficiency, with a low supply of (mainly social) goods and services at relatively high prices. For instance, imperfect competition in the health market may lead to a monopolistic market structure where there will be few suppliers of services who will then have the freedom to charge higher prices. There is therefore no equilibrium in the market, with the real income of most consumers not adequate to pay for the high price of the goods and services in the market. Therefore, government intervention is required to move the market to efficiency.
Government intervention will be through regulation and price fixation in order to bring about efficiency in the market. The government also is expected to produce the public goods and offer incentives to the consumers of these social goods in order to fully address the free-rider effect that results from the imperfect competition. For example, the government may opt to provide free and universal education or health care that will eliminate both excludability in entry and rivaled in consumption.
Externalities
Externalities may either be positive or negative depending on their effect on the consumer. Externalities have social costs associated with them and equilibrium in the market occurs when the marginal social cost equals the marginal social benefit.
In a Pareto efficient market, the consumer will be willing to pay the price of goods that equals the marginal social cost of producing the goods or services. For instance, the externality of pollution means that the extra cost (social cost) of pollution is borne by the consumer without compensation from the producer. In other words, the more the production of goods the higher will be the price the consumer will pay due to the extra social cost and lack of addressing the issue of property rights (Case, Fair, and Oster, 2006).
Government intervention where the externality involves social cost is required in order to reduce the output of the externality to efficiency level. This can be done by imposing taxation on the producer to make him bear the costs of externality and in the process adjust production towards the social equilibrium.
Another way the government can intervene is through imposing restrictions and standards as well as subsidies for innovation to reduce the social cost of the externalities. For instance, the pollution problem can be addressed through technological innovation that will reduce the emissions thus reducing the social cost incurred by the con summers.
Lack of information
Imperfect information by the consumers about the market tends to bring about inefficient markets. Some information is not readily available and therefore the consumer has to bear a cost to obtain it.
The market will be competitive if the marginal cost of obtaining information and using it to make market choices is zero or close to zero. It becomes even worse when the information can not be easily understood by the consumer leading to making choices that are not best for their interests. For example, a patient may not have sufficient information about the treatment required for certain illnesses, where to find the best and affordable health care services, or may not understand the medication jargon, and the cost of making the wrong choice may be disastrous, leading to imperfection in the health market.
Government intervention is required to ensure the availability of complete information through setting standards, regulations, and direct education. For instance, in health care and education, the government may set safety and quality standards or directly provide the services in order to protect those who don’t have the information or are unable to understand the technical jargon used in the market.
Reference
Case, K. E, Fair, R. C. & Oster, S. M. (2006). Principles of Economics. 8th Edition, Boston: Pearson Prentice Hall.