
Efficiency and Markets
Adam Smith observed that people pursuing their own
interests could, if guided by a competitive market, serve
the public interest. The purpose of this section is to show
that Smith was rightthe interaction of individuals in
competitive markets results in economic efficiency.
Other reading units have developed the analytical tools
needed to show that a simple model of an exchange economy
can be economically efficient. In this model, all
transactors must be price takers. This assumption means that
supply and demand curves can be used to represent all
markets. The supply and demand curves of a representative
market, the bread market, are shown in the center of the
graphs below. The graph on the left shows the viewpoint of
the typical buyer, Jane Doe, who is one buyer of a great
many buyers. On the right is a graph showing the viewpoint
of the typical producer, Martha Smith. The price that the
market produces will be P1, the marketclearing
price.
Jane Doe's demand curve for bread is downwardsloping. At
a high price, she buys little, and at a low price she buys
much. The reason for this behavior is that, as she gets more
bread, the value of another loaf declines. In fact, one can
go further and argue that her demand curve shows the
marginal benefit of bread to her. If she is willing to buy
five loaves for $.50 a loaf, but not the sixth loaf at this
price, then the value of the sixth loaf, or its marginal
benefit, must be less than $.50. If the price must drop to
$.45 per loaf before she buys the sixth loaf, her behavior
reveals that the marginal benefit of the sixth loaf is $.45.
Her willingness to pay, which is revealed in her
demand curve, measures her marginal benefit from
bread.
Jane Doe, as a price taker, can buy all she wants at the
market price. To her, the market price appears to be a
supply curve. It is also her marginal cost of buying bread
because it shows how much an additional loaf will cost.
Assuming that she maximizes utility, she will buy until
marginal benefit equals marginal cost, or to the point at
which the price line crosses her demand curve. At price
P1 in the graph, she buys q1 loaves.
Jane Doe is only one of a great many other buyers. To
find out how much all buyers will take at each price, one
needs to add up how much each individual buys at each price.
(This is not a problem in an abstract model, but is clearly
impossible in the real world.) The summation of individual
demand curves yields the market demand curve. Because it is
found by adding marginal benefit curves, the market
demand curve shows the marginal benefit to buyers. This
identity of demand curves and marginal benefit curves is
vital for considering the efficiency of a model of a market
economy.
Marginal costs and benefits look different from the point
of view of Martha Smith, a typical seller in this market. To
her, the fixed price shows the marginal benefits of a
transaction. The price tells her how much more revenue she
gets from selling another loaf of bread. Her marginal cost
curve reflects the value of the resources she must add to
make another loaf of bread. These costs depend on two
things. First, they depend on how much extra resources are
needed to produce another loaf of bread, or the marginal
productivity of resources. This productivity is determined
by the technology of making bread. Second, they depend on
the prices of the needed extra resources, which will depend
on the alternative uses of these resources. If the resources
needed to make bread are high priced, these resources must,
in our simple model, have alternative uses that are highly
valued. Marginal cost curves can slope upward or downward
(recall returns to scale), but only an upwardsloping curve
will give us sellers who are price takers.
Assuming that Martha Smith wants to maximize profits, she
will find that level of output for which marginal revenue,
which is price, equals marginal cost. This profitmaximizing
output can be found on the graph by finding the intersection
of the price line and the seller's marginal cost curve. For
any price, the marginal cost curve tells how many loaves the
profitmaximizing seller will produce. Because a supply
curve also tells how much a seller will sell at given
prices, the marginal cost curve must be a supply curve.
The individual seller is only one of a great many
sellers. The market supply curve is obtained by seeing what
each seller does at a price and then adding up all the
outputs at that price. (Again, this presents no problems in
an abstract model, but is clearly impossible in the real
world.) The result will be a supply curve that can also
be interpreted as a marginal cost curve.^{1}
The point of the previous discussion (you are normal if
you are asking why bother with all this abstract reasoning)
is that the demand curve represents a
marginalbenefittobuyers curve and the supply curve
represents a marginalcosttosellers curve.
However, we are not done yet. In the model of the
exchange economy one can (given a few hidden assumptions)
also show that the marginal cost to the sellers is the same
as the marginal cost to the buyers in the goods market.
Marginal costs to sellers are determined by what the firm
must pay for the resources necessary to produce one more
unit of output. To produce one more unit of commodity A, a
seller must bid resources away from another use. If the
resources were producing output worth an added six dollars
in the alternative use, the seller could not bid them away
for a mere five dollars. If those resources add six dollars
worth of output somewhere else, the seller of product A will
have to pay at least six dollars for them. But he will not
have to pay very much more for them. If we assume perfect
information and the absence of transactions costs, any
amount (however small) over six dollars will cause resources
to move to product A.
The demand curve represents marginal benefit to buyers,
and, because sellers take the price from it, to sellers as
well. The supply curve represents marginal cost not only to
sellers, but also to buyers. It tells both buyers and
sellers what the value of the resources needed to produce
the product is. The maximization principle says that to
maximize net benefit, marginal benefit must equal marginal
cost. As a result, the optimal output, the one that
maximizes value to society, will be the output at which
supply and demand intersectthe amount that the market
provides. This is a remarkable conclusion: Adam Smith was
correct in saying that pursuit of selfinterest could lead
to a socially desirable result. A look at two
other possibilities may help the reader to grasp the
meaning of this conclusion.
^{1}A technical note: to get a
market supply curve by summing up individual supply curves
(or a market demand curve by summing up individual demand
curves), we need to assume that a change in price or
quantity will not affect any of the factors held fixed.
Thus, if higher prices and quantities for output bid up the
price of resources, the individual supply curves would
change, and the assumption that other factors are held fixed
is violated. In this case, a simple addition would not be
correct. This qualification is ignored in the following
discussion.
Copyright
Robert Schenk
