[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Competitive Markets and
Economic Efficiency
The forces of demand and supply determine what is produced, how it is produced,
and who receives the goods that are produced. To many people, relying on competitive
markets seems like an undesirable way of addressing the fundamental economic
questions. Such critics often complain that markets result in too much of
some goods being produced, or too few of others; that allowing markets free rein
leads to inequalities in income and wealth; or that society’s scarce resources could
be used more efficiently if only the government would do something.
Economists have long been concerned with these issues. Are there circumstances
in which markets do a good job in allocating society’s scarce resources? Are there circumstances
in which they don’t? By and large, economists have concluded that competitive
markets, the markets in our basic competitive model, make efficient use of
society’s scarce resources. This faith in markets can be traced back to Adam Smith’s
1776 masterpiece, The Wealth of Nations. Smith argued that workers and producers,
interested only in helping themselves and their families, were the basis of the
success of the economy. As Smith put it,
Man has almost constant occasion for the help of his brethren, and it is in vain for
him to expect it from their benevolence only. He will be more likely to prevail if he
can interest their self-love in his favour, and shew them that it is for their own advantage
to do for him what he requires of them. . . . It is not from the benevolence of the
butcher, the brewer, or the baker, that we expect our dinner, but from their regard
to their own interest. We . . . never talk to them of our own necessities but of their
advantages. 1
In short, Smith argued that individuals pursuing their own self-interest would best
promote the public interest. His insight was that individuals work hardest—and
best—to help the overall economic production of the society when their efforts help
themselves. Smith used the metaphor of the “invisible hand” to describe how selfinterest
leads to social good: “He intends only his own gain, and he is in this, as in many
other cases, led by an invisible hand to promote an end which was no part of his
intention. . . . By pursuing his own interest he frequently promotes that of the
society more effectually than when he really intends to promote it.” 2
This insight is one of the most fundamental in social science, and one that is not
at all obvious. There is more to running an economy efficiently than individuals
simply working hard. How do they know what to produce? How is it that the uncoordinated
pursuit of self-interest then leads to efficiency? One of the most important
achievements of modern economic theory has been to establish in what sense
and under what conditions the market is efficient.
1 The Wealth of Nations (1776), Book One, Chapter II.
2 Ibid., Book Four, Chapter II.
216 ∂ CHAPTER 10 THE EFFICIENCY OF COMPETITIVE MARKETS