Market Efficiency Extended Response - Yr 11 ATAR Economics

Competitive free market definition

Competitive:

. multiple buyers + sellers

. no one buyer or seller can control the price

. low barriers to entry + exit

. availability of substitutes

Free:

. minimal/no gov interference

. individual firms can determine what they produce

. firms keep their profits

Market:

. a product OR resource is capable of being exchanged

. Buyers for and sellers of the product/resource

. has medium of exchange

What is special about competitive free markets?

. are the most efficient way for society to allocate their scarce resources

What do competitive markets do in relation to price and quantity, and allocation of resources?

. establishes an equilibrium price and quantity where demand = supply

. the market allocates resources where the price consumers pay matches the cost of resources used to produce

What is market efficiency?

. producing the goods that society wants at the lowest possible cost

—> efficient outcome = isn’t possible to make someone better off without making someone worse off

—> total wellbeing is maximised, surplus is maximised

What do competitive markets do in relation to production levels

. produce the socially optimal quantity of output

—> the level that maximises the benefits that society can get from its limited supply of resources

—> competitive markets also adjust to changes in supply + demand to ensure that everything is being produced at these optimal levels

What is consumer surplus

. the difference between what a consumer is prepared to pay and what they actually pay

—> economic measurement of consumer benefits

—> profit for consumer

—> equals difference between total benefits and expenditure

—> changes in consumer surplus are a better measure of welfare than changes in consumer expenditure

—> As: if market price falls, increase in consumer surplus as consumers buy more at lower price = economic welfare increases

Why do governments intervene in markets and what may this result in despite their intentions?

. gov intervenes in markets with the idea of resulting in benefits to consumers and/or producers

—> BUT: sometimes when gov intervenes, may decrease economic efficiency, as it can lead to over/under production and thus over/under consumption

—> includes: market restrictions, price controls, gov taxes, gov subsidies

Production quota

. a legislated limit (maximum) on the amount firms are allowed to produce (resulting in disequilibrium?)

—> when the gov tells the firm they can’t sell more than a certain quantity of a good

What are Price controls?

. government regulated min or max prices set for specific products that sets prices either above or below equilibrium price

—> 2 types: price floor and ceiling

What is a price floor and its intention?

. legislated minimum price that sellers are allowed to charge in the market

—> designed to benefit producers by having the price above market clearing price

—> justified on equity grounds = to help low income producers

What is an effective price floor

. the min price set by gov is above equilibrium price

What is an ineffective price floor?

. when a price floor exists, but it’s below equilibrium price

—> no reason why price would fall this low so price floor has no effect (still at equilibrium)

—> effective in this context means one that has an effect on the market

Price Floor example

. Milk prices:

—> governments often aid in sustaining prices by subsidising them or compensating farmers directly

—> this measure is meant to ensure that dairy farms continue operating even when there’s an oversupply of milk (which typically leads to price cuts that destabilise the industry)

What is a price ceiling and its intention?

. legislated maximum price that sellers are allowed to charge in the market for a product or service

—> designed to benefit consumers by keeping the price below market clearing price

—> justified on equity grounds: to help low-income earners afford the good

What is an effective price ceiling

. the max price set by gov is below equilibrium price

What is an ineffective price ceiling?

. when price ceiling exists, but it’s above equilibrium

—> no reason why the price would rise this high, so price ceiling has no effect (still at equilibrium)

What is Total surplus

. the sum of consumer surplus and producer surplus, maximised at market equilibrium

. is a measure of the net benefits to society from the production and consumption of the good

—> total surplus = CS + PS (combined area of CS+PS)

—> total surplus = total benefits - total costs

—> CS does NOT have to equal PS at equilibrium, they may equal different numbers

. a measure of economic efficiency, providing a method to measure how well an economy is solving the economic problem

—> economic efficiency occurs when total surplus is at maximum

—> total surplus only maximised at equilibrium output (is why competitive markets are perfect)

Why do economists like free competitive markets the most?

. ONLY in competitive markets demand = supply

—> thus economists like free, competitive markets as it’s the best way to allocate scarce resources as it leads to the greatest gain for society (max total surplus)

What is a tax?

. a compulsory financial charge or some other type of levy imposed on a taxpayer by a governmental organisation

What is a consumption or sales tax?

. a tax collected based on the sales of products

. a tax paid by the producer per unit sold (usually in part passed on to consumers)

—> effect: decreases supply, a tax where the incidence and impact of the tax are not the same

What are the 4 reasons inelastic goods are chosen to be taxed the most?

1. Generate more gov revenue (can help more people in society)

2. Smaller decrease in total surplus (smaller DWL)

3. Goods tend to be harmful to society (eg. cigarettes) and thus want to discourage consumption

4. Quantity decrease is smaller than with elastic goods, meaning less unemployment as a result

Causes of DWL: Price floor

. leads to overproduction and underconsumption

. leads to surplus

Causes of DWL: Price ceiling

. leads to underproduction and overconsumption

. leads to shortage

Causes of DWL: Tax

. leads to underconsumption and underproduction

Causes of DWL: Subsidy

. leads to overproduction and overconsumption

Causes of DWL: Production quota

. leads to underproduction and underconsumption

What is a subsidy?

. a grant paid to a producer (usually by the gov) with the purpose of reducing costs and increasing output

—> negative tax

What is the effect of price floors on substitute goods?

. for substitute goods, a price floor on one good has an INFLATIONARY effect on the substitute

What is the effect of price floors when placed on a factor of production

. Price of related goods (factor of production): price floor placed on this good = inflation on other related good

—> min price to buy factor of production increased = increased cost of production = producer must increase price they sell their product at resulting in inflation (higher price and lower quantity)

—> Eg: price floor on milk (factor of production of chocolate) means chocolate will raise in price = supply curve shift left (decreases)

What is allocative efficiency?

. looks at the marginal benefit of consumption compared to the marginal cost

—> occurs at an output when MB (price) = MC

—> distributing resources according to consumer preference

What is Productive Efficiency?

. concerned with optimal method of producing goods

—> producing goods society wants at lowest cost

—> producing for the lowest cost

What is Dynamic efficiency?

. an economy or firm’s ability to adapt + improve its productivity over time in response to changing markets, technologies and customer preferences

—> achieved when an economy invests less than the return to capital

—> efficiency over time

What is Producer surplus?

. the difference between the price a producer is willing to receive for a product (min supply price or cost of production) and the price they actually receive

—> profit for producer

What is Deadweight loss (DWL)?

. an avoidable decrease in total surplus because something has prevented the market from producing the optimal output (at equilibrium)

—>results when total surplus is reduced because of either overproduction/consumption or underproduction/consumption

—> thus is a cost to society created by market inefficiency, which occurs when supply and demand are out of equilibrium

. lost potential total surplus due to underproduction/consumption or overproduction/consumption

DWL causes (from production)

. when there is either underproduction (eg in a monopoly) or overproduction (eg. pollution in the environment)

DWL and changes in equilibrium

. a change in equilibrium can lead to either an increase or decrease in total surplus

—> DWL only occurs when a market is prevented from reaching the new equilibrium