Overview

One of the foundations of economics is the idea that markets are efficient. (defined below) It is known that government policy often interferes with market efficiency so that policy gains must be weighed against costs.

Markets can be shown to be efficient only under a set of idealistic assumptions.

• Participants are rational - this assumption has been shown to hold only approximately, and sometimes not at all. (see rational decision making)
• No transaction costs
• Information is free and available

Pareto Efficiency

Pareto Efficiency occurs when no member of the market can be made better off without making another member worse off. Under some fairly ideal assumptions, free markets can be shown to be Pareto efficient.

Market Failures

There are various violations of the assumptions of an ideal market that can lead to market inefficiencies.

• Transaction Barriers
• Externalities
• Price Distortions