Market Efficiency Section 1.1e in SL syllabus

1.1e Market efficiency The workings of a truly free market guarantee that resources will not be used if their value is higher as an unused factor (oil in the ground) rather than their contribution to a produced good or service (plastics). Recall that scarcity requires society to make choices in terms of what to produce. As each decision involves some form of opportunity cost, resources take on a value that is related to their alternative and intended uses.

The market sets a price, which reflects the value of a resource (or a final good or service) through the interaction of buyers and sellers. The price incorporates the opportunity costs perceived by buyers.

Consequently, the price mechanism performs several functions in allocating resources. Prices send a signal to the markets about the relative value placed upon a resource. Prices in this case tell the market where a particular resource is needed/wanted.

The rationing function of prices is most apparent ion shortages and surpluses. In the case of a shortage, if there are tickets for a Foo Fighters concert, prices will ration the seats according to who is most willing to pay for those seats. If the seats are $85, then the seats will be allocated to those who are willing to pay $85 or more. Airplane tickets are another good example based upon the time of day one wants to fly.

Finally, prices perform an incentive function for producers to meet consumer tastes and preferences. When consumers increase their demand for Smartphones, this sends a signal to Apple to produce more iPhone 4s.

How do we take into account various gains to consumers and producers that demonstrate how their utility is maximized? Usually, in a market, we can see the collective benefits to participants through calculating the monetary measure of the increase in total utility.

Consumer surplus is the difference between the maximum price a consumer is willing to pay for a product and the price that they actually pay. A clue to how this measure will work with changes in the market place is to remember that consumer surplus and price are inversely related.

Note that the consumer surplus is the triangle above the equilibrium price representing the additional amount that consumers would have been willing to pay but retain to spend on other goods and services, in this case $5 per unit.

Benefits accrue to sellers via the producer surplus, which is the difference between the actual price received and the minimum price at which they would have been willing to sell the good or service. It is important to note that the producer surplus enjoys a positive relationship with the equilibrium price.

Note that the consumer surplus is the triangle above the equilibrium price representing the additional amount that consumers would have been willing to pay but retain to spend on other goods and services, in this case $5 per unit.

Note that the producer surplus is the triangle below the equilibrium price representing the minimum price at which producers would have been willing to sell the app being $3. In this case the surplus received by sellers is $7 per unit.

The combination of the two triangles, CS and PS represents community surplus.

Equilibrium also indicates that society has used its resources to produce the products most wanted by society. Consequently, this equilibrium is where marginal benefit matches marginal or MB = MC. This is the lesson that made economics relevant to a professor of ethicsAdam Smithback in It is now called allocative efficiency.

Equilibrium prices usually connote another efficiency, which is called productive efficiency.