The Myth of Perfect Allocation

Most economics principles textbooks have some version of the supply and demand chart below:

supply-and-demand-graph

Just your simple equilibrium analysis.  Unfortunately, misunderstanding this chart can lead to comments like this one from Mark Perry’s blog Carpe Diem:

Matthew D:

If the minimum wage causes unemployment because wages are set by supply and demand, and the minimum wage exists above the market clearing wage, this implies that market would clear without a price floor.
In other words, without a minimum wage we would have full employment.  So, the US before the passing for the Fair Labor Standards Act of 1938 had full employment, eh? Full employment was the norm?

What’s incorrect about Mr Matthew D’s comment his his implication: “that markets[s] would clear without a price floor.”  Price theory teaches us no such thing.  No price theorist claims that, absent price controls, markets will always clear (that is, quantity supplied equals quantity demanded).  Rather, that price theory, what the above chart (and subsequent price control analysis), does teach us is that, absent price controls, markets move toward a market-clearing equilibrium and price controls prevent such movement.  In other words, absent price controls, markets work toward the most efficient allocation of resources.  Price controls prevent such movements.

Price theory teaches us as compared to price controls, market allocation will be more efficient than price-control allocation.

Markets are not perfect.  That’s why we need markets.  Markets incentivize people, in ways central planners do not, to find and eliminate these imperfections.Not enough water delivered to area X?  Price of water rises, incentivizing people to bring water to that market, thus fixing the imbalance, for example.  To paraphrase one of my all-time favorite economists and writers, Steve Horwitz, markets exist because we were kicked out of Eden, not because we’re in Eden.

One thought on “The Myth of Perfect Allocation

  1. “[M]arkets exist because we were kicked out of Eden, not because we’re in Eden.”

    Exactly! And, government cannot re-create Eden.

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