Market Efficiency

SPHA511, John Ries

Market Economies and Perfect Competition

• Prices are determined by supply and demand• Demand represents aggregate preferences of

consumers (consumer sovereignty)• Goods are supplied by individuals/firms

pursuing profitable opportunities (economic freedom)

Which nations do not have market economies today?

What characterizes a market economy?

Market Economies and Perfect Competition

• A sufficiently large number of sellers and buyers in a market such that no single buyer or seller believes he can influence the common price at which the commodity is sold. (Prices are taken as exogenous.)

• Free entry and exit.• Perfect knowledge of opportunities for

profitable exchange.

What characterizes perfect competition?

Market Economies and Perfect Competition

Two quotes from Adam Smith

"An individual generally neither intends to promote the public interest nor knows by how much he is promoting it... By directing industry in such a manner as its product may be of greatest value, the entrepreneur intends only his own personal gain, and he is in this aim... led as if by an 'invisible hand' to promote an end which was no part of his intention"

"By pursuing his own self-interest, the entrepreneur frequently promotes that of society more effectually than when he means to promote it"

(from Adam Smith, The Wealth of Nations, 1776)

Market efficiency

Price

Quantity

S=MC

D=MB

PC

QC

Market Economies and Perfect Competition

First Theorem of Welfare Economics

Competitive equilibria are Pareto-efficient (recall that this implies both production and allocational efficiency). In other words, there exists no possible way to reallocate resources so as to benefit one or more participants without making at least one other participant worse off.

Market efficiency and social welfare

a. Recall that each point on the demand curve represents willingness to pay and that allocation efficiency requires that marginal willingness to pay equals marginal cost.

b. Consider a developer deciding whether to build low-income housing or a golf course on a plot of land. With very unequal incomes, willingness to pay may be very high for the golf course and thus the developer may build a golf course.

Is this resource allocation Pareto efficient? Is it socially optimal to build the golf course?

Market efficiency and social welfare

Second Theorem of Welfare Economics:

Redistributing income and letting competitive markets operate will generate a Pareto efficient outcome.

Suppose you redistributed income from rich golfers to the unemployed. In that case the developer may choose to build the low-income housing. This outcome is Pareto efficient.

Market Economies and Welfare

Policy implications

(1) The competitive market is (Pareto) efficient

(2) Government may choose to reallocate income to move from one Pareto efficiency point to another that it deems more socially desirable.

Income redistribution, however, may have undesirable incentive effects.

Trading off efficiency for equity

• Ideally, we prefer outcomes that are Pareto efficient

• However, straight income redistribution in order to achieve an optimal Pareto efficient distribution may be undesirable due to its effect on effort

• Thus, society may choose to tolerate some inefficiency in order to achieve more equitable outcomes

Understanding the trade-off• Consider the following market interventions that

aim to help certain people in society– Minimum wage (w’>wc)– Rent control (r’<rc)– Limited supply (Q’<Qc)– A sales tax to pay for public services

• Draw a supply and demand graph with the intervention to show the efficiency and redistribution effects

Equity versus efficiency

• Competitive markets generate Pareto efficiency but there are many Pareto efficient outcomes that are possible

• Governments certainly may choose to tolerate some inefficiencies to achieve equity objectives

• However, to make good policy, we need to understand the trade-off and the total redistribution effects across groups in our society

• Simply economic tools allows these tradeoffs to clearly depicted