Adam Smith recognized that the virtues of the market mechanism are fully realized only when the checks and balances of perfect competition are present. What is meant by perfect competition? This is a technical term that refers to a market in which no firm or consumer is large enough to affect the market price. For example, the wheat market is perfectly competitive because the largest wheat farm, producing only a minuscule fraction of the world’s wheat, can have no appreciable effect upon the price of wheat.
The invisible-hand doctrine applies to economies in which all the markets are perfectly. competitive. Perfectly competitive markets will produce an efficient allocation of resources, so the economy is on its production-possibility frontier. When as industries are subject to the checks and balances of perfect competition, as we will see later in this book, markets will produce the bundle’ of outputs most desired by consumers using the most efficient techniques and the minimum amount of inputs.
Alas, there are many ways that markets can fall short of efficient perfect competition. The three most important involve imperfect competition, such as monopolies; externalizes, such as pollution; and public goods, such as national defense and lighthouses. In each case, market failure leads to inefficient production or consumption, and government can plays useful role in curing the disease.
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