The Joy of Economics:  Making Sense out of Life
 Robert J. Stonebraker, Winthrop University
 

Market Efficiency

            Efficiency of a practically flawless nature may be reached naturally in the struggle for bread.

                                                                                               ..... author Joseph Conrad

Free markets allocate most resources in the U.S. economy, but do they do it efficiently?  The answer often is: “yes.”

Allocative efficiency

To get the most valuable combination of goods and services -- what he have called allocative efficiency -- goods and services should be produced only if their marginal benefit (MB) is greater than or equal to their marginal cost (MC).  This occurs automatically in many competitive markets. We already know that competitive markets produce where the demand curve intersects the supply curve.  This also is the point at which MB = MC.

Remember that a demand curve shows the prices we are willing to pay.  And the price we are willing to pay reflects the dollar value or MB we expect to get from that good.  For example, if a consumer expects to get $7 of MB from the 31st unit of a good, then he/she will be willing to pay anything up to $7 to get it. Or, if consumer is willing to pay $12 to buy the 8th unit of a good, then he/she must expect to get $12 of MB from it.  Since the demand curve shows prices we are willing to pay, and these prices reflect our MB's, then the demand curve is a MB curve. 

We also know that the competitive supply curve reflects MC's.  Since competitive firms assume they can sell all they want at the going price, they are willing to supply additional units as long as that price covers their marginal costs.

Since demand represents MB and supply represents MC, the competitive equilibrium where the quantity demanded equals the quantity supplied is also the point at which MB = MC.  In the graph below, allocative efficiency occurs at output Q₀.  At this point we are producing all units for which MB covers MC.  This also is the equilibrium output toward which any perfectly competitive industry will eventually move.

No other output is allocatively efficient.  If we produce less (output Q₁ in the graph below), we forego potential gains.  All units from Q₁ to Q₀ bring a MB that exceeds their MC; these units generate surplus value.  If we fail to produce these units, we lose the surplus value they would have created.  If we produce more (output Q₂ in the graph below), the opposite problem occurs.  Since the units past Q₀ cost more than they are worth to consumers at the margin, they generate a net loss to society. 

Technical efficiency

For technical efficiency, we want the Q₀ units produced in the least-cost way.  We do not want firms to use any more scarce resources than is absolutely necessary.  In a competitive industry, this should happen automatically.  Competitive pressure forces firms to adopt least-cost technologies.  If higher-cost methods are used, new firms using the better methods could enter and drive high-cost producers out of the market.  Only least-cost producers will survive in the long run.

But not always

The result that firms in competitive markets produce the most valuable combination of goods and services in the most efficient way is remarkable.  Think about it.  Firms have license to earn as much profit as they can.  They are free to pursue self-interest and produce what and however they want.  Potential consumer greed is unleashed as well.  Consumers can freely pursue self-interest and buy whatever they want.  Yet, this unabashed pursuit of self-interest by both buyers and sellers combine to produce a result that maximizes the value society gets from its scarce resources.  We end up with the best combination of goods and services produced in the best way.   Competitive markets turn the unfettered pursuit of self-interest or greed into a socially efficient outcome.  Absolutely remarkable.

If only it worked all of the time.  Alas, it does not.  Markets often are less competitive than we might like.  And firms that face limited competition can exploit their market power. In competitive markets, firms that fail to produce efficiently what consumers want do not survive.  If one grocer refuses us the best possible deal, we can cross the street to another.  However, none of us wants to be the wayward tourist whose car self-destructs 1,000 miles from home in an isolated town with a single auto repair shop.  Falling prey to potentially predatory monopoly power is not the road to efficiency.

Even when markets are competitive, a second demon might impede efficient results: external effects.  What if my actions impact others?  What is efficient for me might not be for them.  For example, in a truly free world I might be allowed to play music as loud as I like -- even at 3 a.m. when the residents of adjacent apartments are trying to sleep.  In a truly free world I might be allowed to dispose of my trash however I like -- even if it means throwing it on my neighbor's lawn.  Allowing citizens to pursue self-interest in these cases will not necessarily advance the public interest.  One person's freedom can impinge on another's.

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Testing Yourself

To test your understanding of the major concepts in this reading, try answering the following:

1.        Explain why marginal benefit curves are demand curves.

2.        Draw a graph to explain and illustrate why allocative efficiency occurs where the MB (or demand) and MC (or supply) curves intersect.

3.        Explain why outputs higher than or lower than the equilibrium create lost welfare for society.

4.        Explain how and why competitive markets often create technical efficiency.

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