In
neoclassical economics
Neoclassical economics is an approach to economics in which the production, consumption and valuation (pricing) of goods and services are observed as driven by the supply and demand model. According to this line of thought, the value of a good ...
, a market distortion is any event in which a
market
Market is a term used to describe concepts such as:
*Market (economics), system in which parties engage in transactions according to supply and demand
*Market economy
*Marketplace, a physical marketplace or public market
Geography
*Märket, an ...
reaches a
market clearing
In economics, market clearing is the process by which, in an economic market, the supply of whatever is traded is equated to the demand so that there is no excess supply or demand. The new classical economics assumes that in any given market, assum ...
price for an item that is substantially different from the price that a market would achieve while operating under conditions of
perfect competition
In economics, specifically general equilibrium theory, a perfect market, also known as an atomistic market, is defined by several idealizing conditions, collectively called perfect competition, or atomistic competition. In Economic model, theoret ...
and state enforcement of
legal contract
A contract is a legally enforceable agreement between two or more parties that creates, defines, and governs mutual rights and obligations between them. A contract typically involves the transfer of goods, services, money, or a promise to tran ...
s and the
ownership
Ownership is the state or fact of legal possession and control over property, which may be any asset, tangible or intangible. Ownership can involve multiple rights, collectively referred to as title, which may be separated and held by different ...
of
private property
Private property is a legal designation for the ownership of property by non-governmental legal entities. Private property is distinguishable from public property and personal property, which is owned by a state entity, and from collective or ...
. A distortion is "any departure from the ideal of perfect competition that therefore interferes with economic agents maximizing social welfare when they maximize their own". A proportional wage-income tax, for instance, is distortionary, whereas a
lump-sum tax
A lump-sum tax is a special way of taxation, based on a fixed amount, rather than on the real circumstance of the taxed entity. is not. In a
competitive equilibrium
Competitive equilibrium (also called: Walrasian equilibrium) is a concept of economic equilibrium introduced by Kenneth Arrow and Gérard Debreu in 1951 appropriate for the analysis of commodity markets with flexible prices and many traders, and s ...
, a proportional wage income tax discourages work.
In
perfect competition
In economics, specifically general equilibrium theory, a perfect market, also known as an atomistic market, is defined by several idealizing conditions, collectively called perfect competition, or atomistic competition. In Economic model, theoret ...
with no externalities, there is zero distortion at market equilibrium of
supply and demand
In microeconomics, supply and demand is an economic model of price determination in a Market (economics), market. It postulates that, Ceteris paribus, holding all else equal, in a perfect competition, competitive market, the unit price for a ...
where
price
A price is the (usually not negative) quantity of payment or compensation given by one party to another in return for goods or services. In some situations, the price of production has a different name. If the product is a "good" in the c ...
equals
marginal cost
In economics, the marginal cost is the change in the total cost that arises when the quantity produced is incremented, the cost of producing additional quantity. In some contexts, it refers to an increment of one unit of output, and in others it r ...
for each firm and product. More generally, a measure of distortion is the deviation between the market price of a good and its
marginal
Marginal may refer to:
* ''Marginal'' (album), the third album of the Belgian rock band Dead Man Ray, released in 2001
* ''Marginal'' (manga)
* '' El Marginal'', Argentine TV series
* Marginal seat or marginal constituency or marginal, in polit ...
social cost
Social cost in neoclassical economics is the sum of the private costs resulting from a transaction and the costs imposed on the consumers as a consequence of being exposed to the transaction for which they are not compensated or charged. In other w ...
, that is, the difference between the
marginal rate of substitution
In economics, the marginal rate of substitution (MRS) is the rate at which a consumer can give up some amount of one good in exchange for another good while maintaining the same level of utility. At equilibrium consumption levels (assuming no exte ...
in consumption and the
marginal rate of transformation
Marginal may refer to:
* ''Marginal'' (album), the third album of the Belgian rock band Dead Man Ray, released in 2001
* ''Marginal'' (manga)
* '' El Marginal'', Argentine TV series
* Marginal seat or marginal constituency or marginal, in polit ...
in production. Such a deviation may result from government
regulation
Regulation is the management of complex systems according to a set of rules and trends. In systems theory, these types of rules exist in various fields of biology and society, but the term has slightly different meanings according to context. For ...
,
monopoly
A monopoly (from Greek language, Greek el, μόνος, mónos, single, alone, label=none and el, πωλεῖν, pōleîn, to sell, label=none), as described by Irving Fisher, is a market with the "absence of competition", creating a situati ...
tariff
A tariff is a tax imposed by the government of a country or by a supranational union on imports or exports of goods. Besides being a source of revenue for the government, import duties can also be a form of regulation of foreign trade and poli ...
s and
import quota
An import quota is a type of trade restriction that sets a physical limit on the quantity of a good that can be imported into a country in a given period of time.
Quotas, like other trade restrictions, are typically used to benefit the producers o ...
s, which in theory may give rise to
rent seeking
Rent-seeking is the act of growing one's existing wealth without creating new wealth by manipulating the social or political environment.
Rent-seeking activities have negative effects on the rest of society. They result in reduced economic effic ...
. Other sources of distortions are uncorrected
externalities
In economics, an externality or external cost is an indirect cost or benefit to an uninvolved third party that arises as an effect of another party's (or parties') activity. Externalities can be considered as unpriced goods involved in either co ...
, different tax rates on goods or income,
inflation
In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...
, and
incomplete information
In economics and game theory, complete information is an economic situation or game in which knowledge about other market participants or players is available to all participants. The utility functions (including risk aversion), payoffs, strategies ...
. Each of these may lead to a net loss in
social surplus
In mainstream economics, economic surplus, also known as total welfare or total social welfare or Marshallian surplus (after Alfred Marshall), is either of two related quantities:
* Consumer surplus, or consumers' surplus, is the monetary gain ...
.
[• ]T. N. Srinivasan
T. N. Srinivasan, in full Thirukodikaval Nilakanta Srinivasan (27 March 1933 – 11 November 2018), was an Indian economist who had taught and worked in the United States. He was the Professor#Retired faculty 2, Emeritus Samuel C. Park, Jr. Prof ...
(1987). "distortions," '' The New Palgrave: A Dictionary of Economics'', v. 1, pp. 865-67.
• Joel Slemrod (1990). "Optimal Taxation and Optimal Tax Systems," ''Journal of Economic Perspectives'', 4(1),
p. 157
178. Market distortions are events, decisions, or interventions taken by governments, companies, or other agents, often in order to influence the market. They are often the response on market failures, i.e., circumstances that prevent perfect competition and achieving an optimal equilibrium in the market.
In the context of markets, "perfect competition" means:
* all participants have
complete information
In economics and game theory, complete information is an economic situation or game in which knowledge about other market participants or players is available to all participants. The utility functions (including risk aversion), payoffs, strategies ...
,
* there are no
entry
Entry may refer to:
*Entry, West Virginia, an unincorporated community in the United States
*Entry (cards), a term used in trick-taking card-games
*Entry (economics), a term in connection with markets
* ''Entry'' (film), a 2013 Indian Malayalam fil ...
or
exit barriers to the market,
* there are no
transaction cost
In economics and related disciplines, a transaction cost is a cost in making any economic trade when participating in a market. Oliver E. Williamson defines transaction costs as the costs of running an economic system of companies, and unlike produ ...
s or
subsidies
A subsidy or government incentive is a form of financial aid or support extended to an economic sector (business, or individual) generally with the aim of promoting economic and social policy. Although commonly extended from the government, the ter ...
affecting the market,
* all firms have
constant returns to scale
In economics, returns to scale describe what happens to long-run returns as the scale of production increases, when all input levels including physical capital usage are variable (able to be set by the firm). The concept of returns to scale arises ...
, and
* all market participants are independent
rational
Rationality is the quality of being guided by or based on reasons. In this regard, a person acts rationally if they have a good reason for what they do or a belief is rational if it is based on strong evidence. This quality can apply to an abi ...
actors.
Many different kinds of events, actions, policies, or beliefs can bring about a market distortion. For example:
* almost all types of
taxes
A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity) by a governmental organization in order to fund government spending and various public expenditures (regional, local, or ...
and
subsidies
A subsidy or government incentive is a form of financial aid or support extended to an economic sector (business, or individual) generally with the aim of promoting economic and social policy. Although commonly extended from the government, the ter ...
, but especially
excise
file:Lincoln Beer Stamp 1871.JPG, upright=1.2, 1871 U.S. Revenue stamp for 1/6 barrel of beer. Brewers would receive the stamp sheets, cut them into individual stamps, cancel them, and paste them over the Bunghole, bung of the beer barrel so when ...
or
ad valorem
An ''ad valorem'' tax (Latin for "according to value") is a tax whose amount is based on the value of a transaction or of property. It is typically imposed at the time of a transaction, as in the case of a sales tax or value-added tax (VAT). An ...
taxes/subsidies,
*
asymmetric information
In contract theory and economics, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other.
Information asymmetry creates an imbalance of power in transactions, which can ...
or
uncertainty
Uncertainty refers to epistemic situations involving imperfect or unknown information. It applies to predictions of future events, to physical measurements that are already made, or to the unknown. Uncertainty arises in partially observable or ...
among market participants,
* any policy or action that restricts information critical to the market,
*
monopoly
A monopoly (from Greek language, Greek el, μόνος, mónos, single, alone, label=none and el, πωλεῖν, pōleîn, to sell, label=none), as described by Irving Fisher, is a market with the "absence of competition", creating a situati ...
,
oligopoly
An oligopoly (from Greek ὀλίγος, ''oligos'' "few" and πωλεῖν, ''polein'' "to sell") is a market structure in which a market or industry is dominated by a small number of large sellers or producers. Oligopolies often result from ...
, or
monopsony
In economics, a monopsony is a market structure in which a single buyer substantially controls the market as the major purchaser of goods and services offered by many would-be sellers. The microeconomic theory of monopsony assumes a single entity ...
powers of market participants,
* criminal coercion or subversion of legal contracts,
*
illiquidity of the market (lack of buyers, sellers, product, or
money
Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The primary functions which distinguish money are as ...
),
* collusion among market participants,
* mass non-rational behavior by market participants,
* price supports or subsidies,
* failure of government to provide a stable
currency
A currency, "in circulation", from la, currens, -entis, literally meaning "running" or "traversing" is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins.
A more general def ...
,
* failure of government to enforce the
Rule of Law
The rule of law is the political philosophy that all citizens and institutions within a country, state, or community are accountable to the same laws, including lawmakers and leaders. The rule of law is defined in the ''Encyclopedia Britannica ...
,
* failure of government to protect
property rights
The right to property, or the right to own property (cf. ownership) is often classified as a human right for natural persons regarding their possessions. A general recognition of a right to private property is found more rarely and is typically ...
,
* failure of government to regulate non-competitive market behavior,
* stifling or corrupt
government regulation
Regulation is the management of complex systems according to a set of rules and trends. In systems theory, these types of rules exist in various fields of biology and society, but the term has slightly different meanings according to context. For ...
.
* nonconvex consumer preference sets
* market
externalities
In economics, an externality or external cost is an indirect cost or benefit to an uninvolved third party that arises as an effect of another party's (or parties') activity. Externalities can be considered as unpriced goods involved in either co ...
* natural factors that impede competition between firms, such as occurs in
land
Land, also known as dry land, ground, or earth, is the solid terrestrial surface of the planet Earth that is not submerged by the ocean or other bodies of water. It makes up 29% of Earth's surface and includes the continents and various islan ...
markets
See also
*
Deadweight loss
In economics, deadweight loss is the difference in production and consumption of any given product or service including government tax. The presence of deadweight loss is most commonly identified when the quantity produced ''relative'' to the amoun ...
*
Excess burden of taxation
In economics, the excess burden of taxation, also known as the deadweight cost or deadweight loss of taxation, is one of the economic losses that society suffers as the result of taxes or subsidies. Economic theory posits that distortions change ...
*
Government failure
Government failure, in the context of public economics, is an economic inefficiency caused by a government intervention, if the inefficiency would not exist in a true free market. The costs of the government intervention are greater than the bene ...
*
Imperfect competition In economics, imperfect competition refers to a situation where the characteristics of an economic market do not fulfil all the necessary conditions of a perfectly competitive market. Imperfect competition will cause market inefficiency when it hap ...
*
Land value tax
A land value tax (LVT) is a levy on the value of land (economics), land without regard to buildings, personal property and other land improvement, improvements. It is also known as a location value tax, a point valuation tax, a site valuation ta ...
*
Lump-sum tax
A lump-sum tax is a special way of taxation, based on a fixed amount, rather than on the real circumstance of the taxed entity.
*
Market failure
In neoclassical economics, market failure is a situation in which the allocation of goods and services by a free market is not Pareto efficient, often leading to a net loss of economic value. Market failures can be viewed as scenarios where indiv ...
*
Optimal tax
Optimal tax theory or the theory of optimal taxation is the study of designing and implementing a tax that maximises a social welfare function subject to economic constraints. The social welfare function used is typically a function of individual ...
*
Laffer Curve
In economics, the Laffer curve illustrates a theoretical relationship between rates of taxation and the resulting levels of the government's tax revenue. The Laffer curve assumes that no tax revenue is raised at the extreme tax rates of 0% and ...
*
Welfare economics
Welfare economics is a branch of economics that uses microeconomic techniques to evaluate well-being (welfare) at the aggregate (economy-wide) level.
Attempting to apply the principles of welfare economics gives rise to the field of public econ ...
References
Financial markets
Economic efficiency
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