Suppose that you are the chief economist for a benevolent dictatorship. You are given the following assignment.
You are to allocate all of the resources in the economy. We will give you whatever information you ask for. Based on that information, you must tell each person how much to work each day, and at what job. You must decide how much of every intermediate and final good to produce. You must decide which combination of inputs to use to produce every good. You must decide how much of each final good to give to each person to consume. When you make all of these millions of decisions, they have to satisfy this rule for economic efficiency: each person in the economy is as well off as he or she could possibly be without making someone else worse off. That is, when you are finished with your allocations, there is no re-allocation that could improve the happiness of one person while leaving everyone else's happiness unchanged or improved.
(The efficiency criterion is know as Pareto optimality, after Italian economist Vilfredo Pareto, who articulated the concept in 1906. It is a condition for efficiency, but it has nothing to say about equity or fairness.)
As the chief economist for a benevolent dictatorship, you probably would find your task overwhelming. Trying to allocate resources among millions of different uses to try to produce an efficient result seems to be an immensely complex task.
What we will be learning in this part of the course is that when property rights are clearly defined and markets are competitive, the resource allocation that takes place on the basis of decentralized individual decisions achieves Pareto optimality. Even if as chief economist for a benevolent dictatorship you were given complete information about technology, skills, and individual preferences, you could not devise a better allocation than what will be arrived at by the market. Economists view markets as a remarkable decentralized process for processing information and allocating resources.
We also learn from the study of markets, or microeconomics, that there are situations in which the market allocation mechanism will lead to an outcome that is not efficient. Understanding these potential market failure situations helps us to identify opportunities where government intervention might improve on the decentralized market outcome.