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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 right--the 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 market-clearing price.

Buyer, seller, and the market

Jane Doe's demand curve for bread is downward-sloping. 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 upward-sloping 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 profit-maximizing 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 profit-maximizing 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 marginal-benefit-to-buyers curve and the supply curve represents a marginal-cost-to-sellers 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 intersect--the amount that the market provides. This is a remarkable conclusion: Adam Smith was correct in saying that pursuit of self-interest could lead to a socially desirable result. A look at two other possibilities may help the reader to grasp the meaning of this conclusion.

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1A 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