One source of divergence is the exi

One source of divergence is the existence of a market failure. A market fails if it does not generate competitive prices that reflect social opportunity cost and lead to an efficient allocation of products or factors. Three basic types of market failures create divergences. The first is monopoly (seller control over market prices) or monopsony (buyer control over market prices). The second are negative externalities (costs for which the imposer cannot be charged) or positive externalities (benefits f or which the provider cannot receive compensation). The third are factor market imperfections (in adequate development of institutions to provide competitive services and full information).
Efficient policy is a government intervention to correct a market failure and thus offset a divergence. For example, successful regulation of a monopoly would reduce seller prices, cause private and social pr ices to become equal, and increase income.
The second source of divergence is distorting government policy. Distorting policy prevents an efficient allocation of resources to further non- efficiency objectives (equity or security) an d thus creates divergences. A tariff on rice imports, for example, could be imposed to raise farmer incomes (equity objective) and increase domestic rice production (security objective), but it would create efficiency losses if the replaced rice imports were cheaper than the cost s of domestic resources used to produce the additional rice (as explained in the fifth lecture in this series ). Hence, a trade-off would arise, and policy makers would need to assign weights to these conflicting objectives to decide whether to introduce the tariff.
The most efficient outcome could be achieved, in principle, if the government were able to enact efficient policies that offset market failures and if the government were to decide to override non-efficiency objectives and remove distorting policies. If these actions – the introduction of efficient policies and the removal of distorting policies – could be carried out, divergences would be offset and the effects of divergences (measured in the bottom row of PAM) would be zero. In this idealized example, all entries in the bottom row of the PAM matrix – I, J, K, and L – would be zero and the entries in the top row would be identical to those in the second row, i.e., private revenues, costs, and profits would be the same as social revenues, costs, and profits (A = E, B = F, C = G, and D = H).