The efficiency of the market system

In older we defined the concepts of productive efficiency and allocative efficiency,and mentioned that, under certain conditions, the free market could be

shown to bring the economy to an efficient point so defined. The analysis of the

market system in this article enables us to provide an intuitive explanation of

why this might be the case.

Consider, first, the demand curve. It shows how much people are willing to purchase at each price. The person who bought the OQth unit of the good in

Figure 3.10 did so because the utility received from it made it just worth the price OP. The consumer tries to ensure that the extra utility obtained from an additional purchase is proportional to its price. This extra utility is termed marginal utility. When deciding how to allocate our income among competing desirable items, we implicitly compare marginal utility and price. If pears cost twice as much as oranges, we assume that, in a free market, utility-maximising consumers will arrange their purchases so that the marginal utility provided by the last kilogram of pears purchased is double the marginal utility of the last kilogram of oranges. Suppose this condition were breached and the utility of pears were four times the marginal utility of oranges. Then the consumer could add to utility, within a fixed budget, by buying more pears and fewer oranges. The utility maximising assumption will dictate a continuance of this reallocation until the 2:1 ratio is reached. Free market prices reflect marginal utilities.

Next, consider the supply curve, SS. This represents the cost of producing the product. The extra cost of producing the OQth unit of output, otherwise known as its marginal cost, is QS. The supply curve slopes upwards because, in the short run, unit costs are assumed to rise as output increases. Hence, at a higher price it

becomes profitable to produce more output and firms continue producing more

until marginal cost equals that higher price. The connection between costs and

price at firm level will be explained fully. For the present, all we need

to understand is that the supply curve indicates the marginal cost of producing

any given level of output.

This is achieved not because market participants are consciously striving to achieve an efficient outcome in the economist’s sense. Rather, they are being driven by the

desire on the part of consumers to maximise utility and on the part of producers

to maximise profits. We are back to Adam Smith’s ‘invisible hand’, leading

market agents to a socially beneficial outcome which was no part of their original

intention. Competition leads profit-seeking producers to provide what consumers

want to purchase at the lowest possible price. While free market competition

tends to lead the economy towards static efficiency, it also has important

dynamic efficiency effects. Over time, pressures of competition will ensure that

costs are kept to a minimum. A free market with competition gives firms a powerful

incentive to seek more effective ways of producing and distributing their

output, through rationalisation and innovation. For most industries, we think of

this process as involving continuing shifts of the supply curve to the right.

The case for competition and the free market as a generator of economic efficiency is subject to many qualifications. The ‘invisible hand’ is itself in need of

guidance. Discussion on these matters is a live issue as many industrial countries

attempt to become more market-oriented and as countries in transition decide on

the type of market institutions most suited for their needs.