Efficientcy of Competitive Markets

A free market economy is an economic system in which what to produce, how to produce, for whom to produce and other major economic decisions are settled/determined by demand and supply with little or no interference from the government. Thus, competition will be fierce as there will be lot of businesses and consumers. Resource allocation refers to the way in which factors of production are distributed to produce numerous goods and services. In free market economy, factors of production (resources) are allocated through interaction of market forces (demand and supply). What to produce is determined by products’ demand, how to produce is determined by producers based on costs/profit, and for whom to produce is determined by purchasing power of customers/consumers. An increase in demand raises price which leads to more revenue for businesses. This motivates businesses to use more resources into the production of that service/product. Demand for resources are derived from the demand for the final product (Derived Demand).

Consumption depends on consumers income and income itself depends on the market value of an individual's work. In the above diagram, an increase in demand for the product led to an increase in price for the product. This will motivate businesses to allocate more resources in to production of that particular product as they may expect more revenue. Hence, this increased the demand for labor (a resource) leading an increase in wages.

Supply of resources is affected by various factors and changes in supply of resources can be illustrated on a production possibility frontier (PPF). An inward shift of PPF means that resources have decreased which might be due to a natural disaster, high emigration, more social problems, etc. An outward shift of PPF means that resources have increased which might be due to technological advancement, training, quality education, increase in population, etc. (Jeff, 2018) The advantages of resource allocation in a free market economy are:

• Resource allocation is based on consumers’ needs and wants.
• Profit motive forces manufacturers/producers to decrease costs and increase efficiency.
• Profit motive persuades businesses to be more inventive and innovative. Hence, resources are allocated towards better services/products.

Economic Surplus (total welfare) is sum of producer surplus and consumer surplus in an economy. Producer surplus refers to the difference between the market price and the price that the supplier is willing to sell. This is the benefit obtained by the supplier. Consumer surplus refers to the difference between the market price and the price that the consumer is willing to buy. This is the benefit obtained by the consumer.

• Economic Surplus = Producer Surplus + Consumer Surplus
• Producer Surplus = Amount Received By Suppliers – Suppliers’ Cost
• Consumer Surplus = Value To Consumers – Amount Paid By Consumers.

This can be represented on a diagram. Efficiency refers when resource allocation maximizes the surplus gained by all economic actors. The equilibrium point/outcome through the invisible hand of market leads to efficiency in resource allocation. Thus, it maximizes the economic surplus. Moreover, equilibrium outcome decreases costs and increases benefits for both consumers and businesses, as well as for whole society. This is because disequilibrium will lead to inefficiency and market failure.

Efficiency Of Competitive Market Equilibrium

There are various types of efficiency such as allocative efficiency, productive efficiency, dynamic efficiency, technical efficiency, social efficiency, x-efficiency, etc. However, this assignment will emphasize on allocative and productive efficiency. Allocative efficiency refers when all products and services are produced & distributed according to consumers’ preferences. Allocative efficiency occurs when price equals marginal social cost. When allocative efficiency is achieved, there won’t be overproduction and underproduction.

Supply curve can be considered as the marginal social cost curve. Marginal social cost (MSC) is the change in society's total cost due to the production and consumption of an additional unit of service/product. Demand curve can be considered as marginal social benefit curve. Marginal social benefit (MSB) is the change in society's total benefit due to the consumption and production of an additional unit of service/product. Productive efficiency refers to the economic level at which the economy can no longer produce extra quantities of a product without decreasing the production level of another product. This occurs when economy is functioning/operating along its production possibility curve/frontier. Productive inefficiency refers when the economy is operating below its production possibilities curve/frontier, due to underutilization of scarce resources.

Most economists may argue that competitive markets are efficient, but there are some arguments for and against this statement. Competitive markets are likely to exist within a free market economy. Hence, in this assignment “competitive markets” and “free market economy” can be used interchangeably. A competitive market can be efficient, because according to the Adam Smith’s Invisible Hand theory, such markets can achieve equilibrium automatically. Adam Smith recommended that if economic actors were allowed to trade without restrictions, self-centered traders would compete with each other, leading markets towards the equilibrium/positive output. Thus, the equilibrium allows the economy to allocate scarce resources efficiently.

However, Invisible Hand theory is only applicable/suitable if economic actors behave rationally, which is not always the exact reality. Kahneman’s (a psychologist) research shows that it’s common for economic actors to behave irrationally, which contradicts some theories of orthodox economists. Hence, competitive markets may also face inefficiency due to disequilibrium that arises from market forces’ conflicts. Inefficiency may mean that the economy is facing underproduction or overproduction leading a deadweight loss. This may be due to: - subsidies, taxes, high transaction costs, maximum price, minimum price, etc.

Underproduction Overproduction

• 10,000 is the efficient quantity of burger.
• If production is constrained to 5,000 burgers per day, there is underproduction leading inefficiency.
• A deadweight loss equals the reduction in total surplus — the yellow triangle. This loss is a social loss.
• 10,000 is the efficient quantity of burger.
• If production is increased to 15,000 burgers per day, a deadweight loss arises from overproduction. This loss is a social loss.

Competitive markets are more innovative meaning that resource allocation can become more diverse. Hence resources won’t be allocated to only few economic actors, leading more equity and efficiency. This may further intensify the competition, leading equilibrium outcome. However, Competitive markets might not be efficient if there is no adequate/suitable government intervention and such markets usually lack it. In two situations, government intervention is essential/required to prevent inefficiency. They are:

The first is when the actions of either producers or customers result in benefits or costs that do not appear as part of market price. These are called externalities. For example, the cost to the community of air pollution by a producer. Without government intervention, such a producer won’t be motivated to consider the social cost of pollution.

The second situation is market failure. Market failure means that prices fail to provide the appropriate signals to producers and customers, so that market does not function as we have defined it leading inefficiency. Competitive markets often fully utilize resources as such markets will have many producers who need scarce resources for expanding productivity. Unemployed resources might be low leading high possibility for full employment. In the meantime, producers can innovate ways to increase scare resources. Thus, efficiency along with economic growth can be achieved in the long run.

However, it is highly possible that scarce resources won’t be used in the most effective way, as intense competition leads to more exploitation of resources. Most producers won’t consider sustainability since they are too profit motive. Such unethical issues may arise in a competitive market leading high marginal social cost. Thus, the competitive market may not be fully efficient.

Conclusion

In my opinion, competitive markets cannot be always fully efficient unless there is proper government intervention, which is unlikely to happen due to various reasons including corruption, lack of finance, foreign intervention/affairs, etc. However, compared to command economies and uncompetitive markets, competitive markets are more efficient based on facts of orthodox economists. I hope that this assignment would be beneficial for your future endeavors.