Ch 7

Market Efficiency

Market Efficiency
What is the best way to allocate resources? Best way = the most efficient way If the Total Gain is maximized, the market is said to be Efficient. In a pure market economy, only two parties are involved. Total Gain can be divided into two parts:
Consumers gain: Consumer Surplus Producers gain: Producer Surplus

Market Efficiency
1.Consumer Surplus
net benefits that are obtained by a consumer from his consumption of goods. The difference between the consumers willing to pay, in terms of $, and his need to pay, in terms of $. Measured in monetary term. Example:
You are willing to pay $2,000 for a digital camera, but you can buy a for $1,300 Consumer surplus = $2,000 - $1,300 = $700

Market Efficiency
1.Consumer Surplus
If more than one unit is consumed, total consumer surplus = sum of consumer surplus from each unit. P Area between the market demand and the price. P1
Willing to pay P2 P3 P

CS

Shows the max amount you are willing to pay for each unit

D
1 2 3 Q

Market Efficiency
2. Producer Surplus
net benefits that are obtained by a producer from its sale of goods. The difference between the producers need to pay (marginal cost), in terms of $, and his revenue, in terms of $. Measured in monetary term. Example:
The cost of producing a digital camera is $500, but it can be sold for $1,300. Producer surplus = $1,300 - $500 = $800

Market Efficiency
2. Producer Surplus
If more than one unit is sold, total producer surplus = sum of producer surplus from each unit. P Area between the market supply and the price. Marginal cost S curve
P

PS Q

Market Efficiency: Perfect Competition

Is the market perfect competition efficient? Yes. Under Perfect competition, the total gain is maximized. Market P S CS

P1
PS Q1 D Q

Market Efficiency: Perfect Competition

Q1 is the efficient output level, at which the total gain is maximized. Q1 = Pareto optimal output level (from the society point of view) Pareto optimal condition: Demand = Price = Supply
Consumption optimal Production optimal

Consumers willing to pay = Producers need to pay

Market Efficiency: Perfect Competition

What if less than Q1 is produced? No. Total gain is smaller. Market P S Loss in P2 CS total gain. P1 PS Dead-weight-Loss D Q

Q2

Q1

Market Efficiency: Perfect Competition

Producing less than Q1 will create Deadweight loss. Demand > Supply
Consumers Producers willing to pay > need to pay

Produce more to increase total gain Underproduction

Market Efficiency: Perfect Competition

What if more than Q1 is produced? No. Total gain is smaller. Market P S Loss in total gain. P1 CS Dead-weight-Loss
P2

PS Q1

D Q2 Q

Market Efficiency: Perfect Competition

Producing more than Q1 will create Deadweight loss. Demand < Supply
Consumers Producers willing to pay < need to pay

Produce less to increase total gain Overproduction

Market Efficiency: Perfect Competition

The market force, likes a invisible hand helps allocating resources efficiently
Adam Smith (1723-1790)

Father of modern economics

Market Efficiency: Perfect Competition

Capitalism will produce internal tensions which will lead to its destruction. Socialism will in its turn replace capitalism and lead to a stateless, classless society called pure communism which will emerge after a transitional period

Karl Marx 1818 - 1883

I agree with you

Welfare effect of Government intervention

Effect of a price floor:
The government set a price floor P1. DWL P Q1 will be bought. Consumer surplus P1 CS Producer surplus Pe Dead-Weight loss PS Inefficient
Q1 Qe

D Q

Welfare effect of Government intervention

Effect of a price ceiling:
The government set a price floor P1. DWL P Q1 will be bought. Consumer surplus Producer surplus Pe CS Dead-Weight loss P1 PS Inefficient
Q1 Qe

D Q

Welfare effect of Government intervention

Effect of a per unit tax :
The government set a per unit tax t. DWL 2 Price increases to P1 P S S 1 t and Q1 will be bought P1 CS Consumer surplus Pe Tax Producer surplus revenue P1-t PS Government revenue D Dead-Weight loss Q Q1 Qe Inefficient

Welfare effect of Government intervention

Effect of a per unit subsidy :
The government set a per unit subsidy s. DWL 1 Price increases to P1 P S S 2 s and Q1 will be boughtP +s 1 Subsidy CS Pe expenditure Consumer surplus PS P1 Producer surplus Government expenditure D Dead-Weight loss Q Qe Q1 Inefficient

Conclusion
When both consumers and producers maximize their self-interest (utility & profit), the market will allocate resources efficiently automatically. No central coordination is required. Any types of government interventions will create some sorts of inefficiency Dead-Weight Loss. Because the output level will be distorted away from the optimal level (the competitive market equilibrium. Government intervention can only be justified when transaction cost is involved.

Concept Map
Competition Price Competition Market Economy How market work?
P P1 D S

Non-Price Competition
(Order)

Command Economy

Q1

Demand
The theory of consumer (Utility)

Supply
Sum of MC curves of all the competitive firms (price-takers)