Appendix A: Resource Scarcity, Economic Efficiency and Markets: How the Invisible Hand Works

Invisible hand

Competition in markets directs self-interested individuals to do what is beneficial for all of society

5 basic assumptions of efficient markets

1. Freedom of choice

-this is based on self-interest and rational behavior

-rational behavior: buyers and sellers behave consistently with their self-interest

2. Perfect information

-2 aspects of perfect information

a. economic agents have full information about economic transaction

b. economic agents have perfect foresight about future economic events

3. Competition

-this means there are a large number of buyers and sellers in a market

-This means there are a large enough number of buyers and sellers so that each buyer and seller is a price taker, i.e., has no control over market price

4. Mobility of resources

-This means there are no barriers for firms who desire to enter or exit a market

-important implication of mobility of resources: resources can be readily transferred from one economic sector to another

5. Ownership rights

This means all resources have clearly defined property rights

4 characteristics of clearly defined property rights

A. The nature and characteristics of the resources are completely specified

B. Owners have exclusive rights to the resources they legally own

C. Ownership rights are transferable, i.e, resources can be bought and sold at terms agreeable to the owner

D. Ownership rights are enforceable, i.e, property rights are protected by social rule and regulations

Short run market time

Short run:

A. Firms cannot enter or exit a market

B. Resources cannot be transferred between economic sectors

Long run market time

Long run:

A. Firms can enter or exit a market

B. Resources can be transferred between economic sectors

3 characteristics of Long Run equilibrium

1. Firms produce product at minimum ATC

2. Consumers pay lowest price possible

3. Firms make a normal profit

Normal profit

Sufficient profit for a firm to stay in business

In the long run, what forces firms to make a normal profit?

Entry and exit of firms

4 steps how entry leads to normal profits

A. Entry occurs when profits are above-normal

B. Entry increases competition in the market

C. Increased competition decreases the market price

D. A decrease in market price decreases profits to normal profits

4 steps how exit leads to normal profits

A. Exits occurs when profits are below-normal

B. Exit decreases competition in the market

C. Decreased competition increases the market price

D. An increase in market price increases profits to normal profits

Consumers: P=MPB

P=max price consumers are willing to pay and MPB = Marginal private benefit of consuming a product

Why does P=MPB

Because consumers are only willing to pay a price that is equal to the private benefit they receive from a product

Important note

Both willingness to pay and MPB decrease as more of a product is purchased

Important implication

Given certain assumptions, in Long Run equilibrium, consumer welfare or well being is maximized

P= MPC

P=min price producers are willing to accept and MPC = marginal private cost of producing a product

Why does P= MPC

When there is sufficient competition, i.e, a. large number of firms, firm produce where P= MPC

Note: Both willingness to accept and MPC increases as more of a product is sold

Achieving efficiency

In the LR, market price equates the marginal benefit consumers receive from a product to the marginal private costs of firms producing the product

-Under the assumptions listed above, market efficiency is achieved because P= MPB = MPC

Note: When P= MPB = MPC, a market is producing the efficient level of the product

Pareto optimality

Any change in output cannot be made without making society worse off

Implication of pareto optimality

Consumer welfare or well-being is maximized

At LR equilibrium

Pareto optimality is achieved

Pareto optimality implies economic efficiency

How do we know that LR equilibrium implies Pareto Optimality?

1. What if we increase output from LR equilibrium?

2. What if we decrease output from LR equilibrium?

What if we increase output from LR equilibrium?

There is a loss in societys economic welfare or well-being because MBP < MPC

What if we decrease output from LR equilibrium?

-There is a loss of societys economic welfare or well-being because MPB > MPC

-So when a market produces the level of output where P = MBP = MPC, consumer welfare or well being is maximized

If LR equilibrium implies Pareto Optimality

Then we have proved the Invisible Hand Theorem

Price as a measure of resource scarcity

Given the 5 basic assumptions of efficient markets, in LR equilibrium the following will be true: P= MPB = MPC

Given that ownership rights are clearly defined, then private benefits=

Social benefits and private costs which equal social costs, and so the following will be true: P = MPB = MSB = MPC = MSC

MSB

Marginal social benefits

MSC

Marginal social cost

What does it mean when we say market price reflects scarcity?

Given the conditions listed above, market price in LR equilibrium reflects the true scarcity value of the resources used to make a product

What is meant by true scarcity value of resources?

By true scarcity, market price in LR equilibrium reflects the social cost of using resources to produce a product