CHAPTER 9 MARKET EFFICIENCY
So far, we have seen how the forces of demand and supply determine the prevailing price ands quantity in a market. We have also seen how the various elasticity concepts further impact the respective price and quantity variables. Finally, we also learn how the government can disrupt the market equilibrium with several microeconomic policies of taxes, subsides and price control, if the government decides that the market equilibrium is less than desirable.
With respect to the “undesirability” (to be covered from Chapter 10 onwards), let’s first clarify when the market outcome is desirable. The answer is simple: the market is efficient.
9.1 Market Equilibrium
The free market economy has always been regarded as an efficient system in answering the economic problems of what and how much, how and for whom to produce. The market economy makes use of the price mechanism to make the above decisions and to allocate resources according to the wishes of the economy.
Surpluses and shortages are reflected via price changes and this signals to decision-makers what is happening throughout the economy. When shortages occur, prices raise windfall profits result. When gluts occur, prices fall and losses are incurred. Reallocation of resources takes place as firms enter profit-making markets and exit loss-making markets.
9.1.1 Major Characteristics of a Market Economy
A perfectly competitive market economy is said to possess the following characteristics.
1. Consumer Sovereignty
The goods and services produced would be determined by price signals, which reflect consumer wants.
(More on Consumer Sovereignty here.)
2. Decentralised Decision-making
The optimal production and allocation of resources would be achieved without the need for an expensive bureaucracy. In a market economy, the price system acts as a mechanism for resource allocation. This is often referred to as the “invisible hand” principle, describing the proposition that economic order rather than chaos results from the pursuit of individual self interest in a market economy.
3. Economic efficiency is attained
Economic efficiency comprises allocative efficiency and productive efficiency.
a. Productive efficiency is achieved when goods are produced at the lowest achievable cost for a given output.
NB. At the macro level, productive efficiency is achieved at any point on the production possibility curve.
b. Allocative efficiency is achieved when no one can be made better off without someone being made worse off.
Under conditions of perfect competition and the absence of externalities or other market failures, the resulting allocation of resources by the market will be allocatively efficient.
Resources are not used efficiently when they are used to produce goods that nobody wants, or when insufficient amounts of resources are allocated to produce what society is able and willing to pay. If it is possible to make changes to the economy such that these changes benefit some people without making anyone else worse off, economists would describe this as an improvement in the efficiency of resource allocation, termed as allocative efficiency.
Allocation of resources is socially efficient when the marginal benefit to society equals to the marginal cost to society of producing or consuming the good, i.e.
Marginal Social Benefit (MSB) = Marginal Social Cost (MSC).
9.1.2 Concepts of Private and Social Benefits & Costs
1. Social Benefits and Costs
Marginal Social Benefit is the sum of Marginal Private Benefit (MPB) and Marginal External
Benefit (MEB) [MSB = MPB + MEB]
Marginal Social Cost is the sum of Marginal Private Cost (MPC) and Marginal External Cost (MEC) [MSC = MPC + MEC]
2. External Benefits and Costs
External Benefits are benefits from production/ consumption experienced by people other than the producer/consumer. (This will be elaborated in Chapter 10.)
External costs are costs from production/ consumption experienced by people other than the producer/ consumer. (This will be elaborated in the next part of the notes.)
3. Private Benefits and Costs
Under perfect competition with no externalities or other market failures, the resulting allocation of resources by the market will be socially efficient. To understand why this is so, let’s first look at the MPC and MPB concepts.
a. The Marginal Private Cost (MPC) of production measures the cost to the producer from the last unit sold. Under the perfectly competitive market, MPC is represented by the supply curve and at any given quantity, PMC is represented by the height of the supply curve.
b. The Marginal Private Benefit (MPB) of a good measures the value that the consumer places on the last unit of the good bought. For the rational consumer, it is equal to Price (P). Hence, MPB is represented by the demand curve. At any given quantity, the PMB is represented by the height of the demand curve.
Therefore, as can be deduced from above, demand and supply curves contain important information about benefits and cost.
In the absence of government intervention, price adjusts to balance the demand and supply in the market. The equilibrium quantity is Q2 where DD=SS i.e. MPB=MPC. (See figure 1 below). At Q2, the sum of consumer surplus and producer surplus is maximised.
Now, assuming no externalities (i.e. no external cost or external benefit), the resulting allocation of resources by the market will be allocative / socially efficient because at Q2, MSB=MSC.
1. Given that there is no external cost, MSC=MPC since MEC=0.
2. Given that there is no external benefit MSB=MPB since MEB=0.
3. When MSB=MSC, the equilibrium condition for allocative efficiency is achieved. In other words, the allocation of resources has maximized society welfare. And this occurs at Q2.
Now, question is what happens if output is less than or more than Q2?
1. At Q1, where MSB > MSC, society values an extra unit of output more than the cost that will be incurred in its production. And this is the situation faced for any output level that is below Q2. Hence, society’s welfare is not maximized and there is room for improvement in society welfare if production is increased until Q2 is reached. So, currently, there is underproduction of the good.
2. At Q3, where MSB < MSC, society values an extra unit of output less than the cost that will be incurred in its production. And this is the situation faced for any output level that is beyond Q2. Hence, society’s welfare is not maximized and there is room for improvement in society welfare if production is decreased
until Q2 is reached. So, currently, there is overproduction of the good.
3. Thus, welfare (consisting of the sum of consumer surplus and producer surplus) will be maximised when output is at the socially optimal level Q2 where MSB = MSC. At Q2, there will be no more underproduction or overproduction.
9.2 Responses to the 3 Basic Economic Questions
As recalled, the 3 basic economic questions an economy must address are:
1) What and how much (of a good or service) to produce,
2) How to produce,
3) For whom to produce
Clearly, when the market produces exactly what is wanted, and in the correct amount, allocative efficiency is achieved.
If the market produces the good or service at the lowest cost possible, productive efficiency is achieved.
Finally, if the market is able to provide the good to the consumer who needs it the most, then distributive efficiency is achieved.
9.3 Productive Efficiency
If the market produces the good or service at the lowest cost possible, productive efficiency is achieved. It is quick to see that this type of efficiency is also actively pursued by firms themselves, since all lowered costs of production will raise the level of profits earned.
Only the monopolist in reality can be possibly guilty of productive inefficiency. Due to a lack of competition, their resultant complacency and organisational slack often see the monopoly firm using excessive factors of production, and thus incurs higher costs of production.
(This point related to Market Structures & Market Dominance, so H1 Econs students need not be concerned with this concept)
9.4 Distributive Efficiency
Distributive efficiency occurs when goods and services are consumed by those who need them most. Distributive efficiency is concerned with an equitable distribution of resources because of the law of diminishing marginal returns.
The Law of Diminishing Marginal Utility (LDMU) states that as consumption of good increases we tend to get diminishing marginal utility. For example, if a millionaire already has five houses, but gets a fifth house – this fifth house will only increase his net utility by a small amount. If by contrast someone on a low income is able to get their first house, the marginal utility will be much higher.
Therefore, to be distributive efficient, society will need to ensure an equitable distribution of resources.
A monopoly could lead to distributive inefficiency. A monopoly is able to use its market power to set high prices and make super-normal profits. Thus a monopoly owner can gain a higher share of national output, but consumers face higher prices and a decline in consumer surplus.
(Due to the market only ensuring those who are willing and able to buy can consume the good or service, the market is by default, distributively inefficient, synonymously known as inequitable.
9.5 Additional Efficiency Concept: Dynamic Efficiency
Dynamic efficiency is concerned with the productive efficiency of a firm over a period of time. A firm which is dynamically efficient will be reducing its cost curves by implement new production processes.
This type of efficiency will enable a reduction in both SRAC and LRAC. Dynamic efficiency is also concerned with the optimal rate of innovation and investment to improve production processes which help to reduce the long run average cost curves.
Dynamic efficiency may also involve implementing better working practises and better management of human capital. For example, better relationships with unions that helps to introduce new working practises.
However, dynamic efficiency involves a trade-off. To invest in better technology may involve higher costs in the short run. But, without this investment and innovation, the firm may be unable to improve over time. Dynamic efficiency is often examined under the topic of Market Structures, and again, H1 Economics exam candidate need not be concerned with this concept.
9.6 Sample Short Answer Questions
- Explain how a free market equilibrium, can help to address the problem of scarcity.
- Explain why main functions of a market.
- Discuss whether the existence of a monopoly is always undesirable.
(More sample essay questions for Market Failure here.)
The above questions require your knowledge of the content of both supply, demand and strong theoretical efficiency concepts, plus clear exam abilities to secure a “Level 3 response”,. These are known as higher order thinking skills (HOT), taught heavily in our Econs tuition lessons.