The analysis presented in chapter 2 shows that a perfect market economy can be Pareto efficient. If the economy attains a Pareto-efficient allocation of goods and factors, there remains no mutually beneficial exchanges to exploit. This reduces the role of the public sector to that of providing the institutional and legal framework under which markets operate. Possibly, the public sector may also try to affect income and welfare distribution – to reach a particular point on the utility possibilities frontier – in the perfect market economy.

Sometimes, markets fail to work perfectly. We will not engage in the debate over whether market failures are sufficient to motivate government intervention. Rather, we will explain why markets may fail, i.e. why mutual gains are not necessarily fully exploited by decentralized decision-makers. The implications of market failures for welfare economics are also explored. A companion chapter enters more deeply into some of the issues swept over in the present chapter.

Decreasing average costs

Thus far we have assumed that firms operate under what is known as diminishing returns to scale. This ensures that the marginal as well as the average variable cost of production increases as the scale of the firm's operation increases. Facing fixed prices in all relevant markets, a profit-maximizing firm will produce such an amount of output that the fixed revenue obtained from producing the last unit of output equals the cost of producing that unit of output. This case is illustrated graphically in figure 5.1a. The shaded area in the figure represents the short-run producer surplus earned by the firm.