Market distortion

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In neoclassical economics, a market distortion is any event in which a market reaches a market clearing price for an item that is substantially different from the price that a market would achieve while operating under conditions of perfect competition and state enforcement of legal contracts and the ownership of private property. 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".[1] A proportional wage-income tax, for instance, is distortionary, whereas a lump-sum tax is not. In a competitive equilibrium, a proportional wage income tax discourages work.[2]

In perfect competition with no externalities, there is zero distortion at market equilibrium of supply and demand where price equals marginal cost for each firm and product. More generally, a measure of distortion is the deviation between the market price of a good and its marginal social cost, that is, the difference between the marginal rate of substitution in consumption and the marginal rate of transformation in production. Such a deviation may result from government regulation, monopoly tariffs and import quotas, which in theory may give rise to rent seeking. Other sources of distortions are uncorrected externalities,[3] different tax rates on goods or income,[4] inflation,[5] and incomplete information. Each of these may lead to a net loss in social surplus.[6]

In the context of markets, "perfect competition" means:

Many different kinds of events, actions, policies, or beliefs can bring about a market distortion. For example:

  • almost all types of taxes and subsidies, but especially excise or ad valorem taxes/subsidies,
  • asymmetric information or uncertainty among market participants,
  • any policy or action that restricts information critical to the market,
  • monopoly, oligopoly, or monopsony powers of market participants,
  • criminal coercion or subversion of legal contracts,
  • illiquidity of the market (lack of buyers, sellers, product, or money),
  • collusion among market participants,
  • mass non-rational behavior by market participants,
  • price supports or subsidies,
  • failure of government to provide a stable currency,
  • failure of government to enforce the Rule of Law,
  • failure of government to protect property rights,
  • failure of government to regulate non-competitive market behavior,
  • stifling or corrupt government regulation.
  • nonconvex consumer preference sets
  • market externalities
  • natural factors that impede competition between firms, such as occurs in land markets

See also[edit]


  1. ^ Alan Deardorff. "Distortion", Deardorff's Glossary of International Economics.
  2. ^ Stephen D. Williamson (2010). "Sources of Social Inefficiencies," Macroeconomics, 3rd Edition.
  3. ^ Agnar Sandmo (2008). "Pigouvian taxes." The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
  4. ^ •Louis Kaplow (2008). "optimal taxation," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
       • Louis Kaplow (2008). "income taxation and optimal policies," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
       • Alan J. Auerbach (2008). "taxation of corporate profits," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
  5. ^ S. Rao Aiyagari, R. Anton Braun, Zvi Eckstein (1998). "Transaction Services, Inflation, and Welfare," Journal of Political Economy, 106(6), pp. 1274-1301 Archived May 21, 2005, at the Wayback Machine (press +).
  6. ^ T. N. Srinivasan (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 p. 157-178.