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Lecture 5

The lecture discusses the conditions for achieving efficiency in perfectly competitive markets, where resource allocation is Pareto Optimal when all resources are privately owned, transactions occur in markets, and information is freely available. It highlights the roles of buyers and sellers in maximizing their gains through the interplay of supply and demand, leading to market prices that reflect marginal private and social benefits and costs. Additionally, it addresses market failures due to monopolistic power and the inability of certain goods to be efficiently traded, suggesting the need for government intervention in such cases.

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Youstina Magdy
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15 views6 pages

Lecture 5

The lecture discusses the conditions for achieving efficiency in perfectly competitive markets, where resource allocation is Pareto Optimal when all resources are privately owned, transactions occur in markets, and information is freely available. It highlights the roles of buyers and sellers in maximizing their gains through the interplay of supply and demand, leading to market prices that reflect marginal private and social benefits and costs. Additionally, it addresses market failures due to monopolistic power and the inability of certain goods to be efficiently traded, suggesting the need for government intervention in such cases.

Uploaded by

Youstina Magdy
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Lecture 5

MARKETS, PRICES, AND EFFICIENCY CONDITIONS

A system of perfectly competitive markets can result in efficient


resource use in an economy. Conditions under which market is
Pareto Optimal:

1. All resources used in production are privately owned.


2. All transactions take place in markets, and sellers offer a
standardized (identical) product to buyers.
3. No buyers or sellers can influence prices
4. All relevant information is freely available to buyers and
sellers.
5. Resources are mobile and may be freely employed in any
enterprise.

• Both buyers and sellers seek to maximize their gains in such a


system. Buyers maximize the satisfaction they obtain from
exchanging their money for goods and services in markets and
sellers maximize the profits they earn from making goods and
services available to consumers.

• The market prices that emerge reflect the free interplay of supply
and demand. Neither businesses nor buyers can control prices;
they can only react to them.

Consumers (buyers):

• When deciding how much of a good to purchase, buyers consider


their own marginal private benefit (MPB), which is the dollar value
placed on additional units of the good by individual consumers.

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• With the prevailing market prices, consumers buy until they adjust
the marginal private benefit received from consuming a good to
the price of that good.

• If the price exceeds the marginal private benefit of that last unit,
they would be made worse off by trading those dollars for the
good.

• The marginal private benefit received by consumers purchasing the


good is also equal to the marginal social benefit of the good.

• Therefore, they maximize their gains by adjusting the amount of


the good they consume until the marginal private benefit, MPB,
received is just equal to the price, P:

• P = MPB = MSB

Producers (suppliers):

• Producers maximize their gains when they maximize profits. When


it is no longer possible to add any gain by selling one more unit,
profits are maximized. The firm will increase profits whenever the
revenue obtained from selling an additional unit exceeds the cost
of producing and selling that extra unit.

• The marginal private cost (MPC) of output is the cost incurred by


sellers to make an additional unit of output available for sale.

• The extra revenue obtained from selling one more unit is its price.

• The firm will maximize profits when it adjusts its output sold to the
point at which price is equal to the marginal private cost of output.

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If marginal private cost exceeds price, the gains (profit) would
decline. Therefore, producers maximize gains at the point for which

P = MPC = MSC

• The marginal private cost of output incurred by sellers is the


marginal social cost.

∴ P = MPB = MPC = MSB = MSC

• A perfectly competitive market, in which both buyers and sellers


maximize their net gains from trade, will result in a level of output
for which marginal private benefit equals marginal private cost and
therefore the market equilibrium will achieve the efficient output.

• If this condition is met in all markets and all goods are tradable in
markets, the overall allocation of resources in the economy will
satisfy the efficiency criterion.

• When the prices of all goods and services equal the marginal social
benefits and marginal social costs of these items, the market
system achieves an efficient outcome.

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When Does Market Interaction Fail to Achieve Efficiency?

• In the study of government, there are conditions under which


markets and prices fail to result in the efficient outputs of goods
and services. Political action will not always result in net benefits
and government activity itself can cause inefficiency.

• The basic problem that causes inefficiency is that prices do not


always fully reflect the marginal social benefits or marginal social
costs of output. This often occurs because of the nature of certain
goods, which makes them difficult to package and trade easily in
markets.

• For example, no one owns the environmental resources as air and


water and thus market exchange of the right to use these resources
is unlikely. This means that sellers using environmental resources
to make goods available do not pay for the right to use those
resources. This leads to situations in which the marginal private
cost of output incurred falls short of the marginal social cost.

• The failure of markets to price and make certain goods available,


such as national defense, gives rise to demands for government
production and regulation.

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Monopolistic Power

• Markets will fail to result in efficient levels of output when


monopolistic power is exercised. A firm exercises monopolistic
power when it influences the price of the product it sells by
reducing output to a level at which the price it sets exceeds
marginal cost of production.

• A monopolist maximizes profits at a level of output at which


marginal revenue (MR) equals its marginal cost.

• The demand curve for the monopolist’s product reflects the


marginal social benefit of possible levels of output.

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• The monopolistic firm maximizes profits by producing QM units of
output. This output corresponds to point A, at which MR = MSC.

• At that output level, the marginal social benefit of the good exceeds
its marginal social cost, therefore efficiency is not attained at QM.

• Normative economists would prescribe government intervention to


increase output in order to attain efficiency.

• Efficiency could be attained by forcing the monopolist to increase


output until prices fall to a level equal to marginal social cost. The
additional net benefits possible from increasing output from QM to
Q* units are shown by the triangular area ABE.

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