Also available on Charlie's Angel: project.

Economic Theory: Necessary Conditions for
Markets to Achieve Allocative Efficiency

Price theory says that markets achieve allocative efficiency given that certain conditions are met.  Unfortunately, the conditions aren't like the disclaimers on software that you don't have to read (just kidding, of course).  The caveats are broad, and just about every aspect of the information technology industry falls into one or another of these categories.

The conditions that must exist for markets to achieve allocative efficiency are:

• Perfect competition - Perfect competition means that competitors are indistinguishable from one another and their products are completely interchangeable, personal computers have certainly not reached this point, but the semiconductor marketplace may be getting close.

• Perfect information - Perfect information means that buyers and sellers have all the relevant information on their product and the market, something clearly not true of most home computer buyers.

• Perfect mobility of resources - Perfect mobility of resources means no lag times, no barriers to entry, and free flow of capital, resources, and labor.  Obvious exceptions to this condition include training and implementation lag times.

• No externalities - Externalities are effects that accrue to a third party or third parties other than the buyer and seller of the product, and can be positive or negative.  A classic example of negative externalities is environmental damage, such as that caused by the chemicals used in computer chip manufacturing.

• No public goods - Public goods are much like the ultimate in positive externalities: if they exist, they exist for all parties.  The internet is a quasi-public good, having some of the characteristics of true public goods such as national defense.

• No interdependence - No interdependence means no collusion or interconnection between buyers decisions to buy and producers decisions to sell.  Clearly for "vaporware" to work as a strategy, there must be interdependence among software manufacturers decisions to produce software.

• No economies of scale - No economies of scale means that the cost for additional products must at some point (before the total need for that product) increase or spell market failure.  In cases where, like software, the cost of an extra unit of production (marginal cost) is negligible, the biggest competitor in the field always will have the lowest costs.

• No indivisibilities of production  Indivisibilities refers to any factors of production that are "quantized" in units large enough so as to interfere with setting production at the appropriate level.  The amount of code required for a new modern operating system is arguably a good example of a factor of production which cannot exist only in part, and which limits the number of companies able to effectively compete in that market.

• Not critically large transaction costs - This refers to costs associated with making the transaction, e.g. identifying potential suppliers of a software solution that would meet a particular client's needs, that are not accounted for in the cost of the product itself from the buyer's or seller's standpoint.

• Allocation is only correct for given distribution of wealth - Shifts in the distribution of wealth invalidate (to some degree) old models of allocative efficiency.  Internet start-ups becoming billion-dollar companies might have been predicted by an economical model, but the presence of these companies and the wealth that they have generated has now invalidated that model at least as far as allocative efficiency is concerned.  Also technology  and economic growth may change the relative values of types of wealth, effectively redistributing wealth.

  *List adapted from Schickele.

When any of these conditions fails to be met, it is termed a market failure, and it is considered, by economists, the rightful role of government to correct for these market failures.  Obviously classical economic theory leaves a large role for government to play in the economy.

What are some of the chief areas in technology that government intervention is warranted?  What type economic issues and theories are involved?  And what policies would economists suggest in these fields?  These are the questions that this project seeks to answer in its evaluation of information technology's public policy hotspots.