AGGREGATE EXPENDITURE LINE: A line representing the relation between aggregate expenditures and gross domestic product used in the Keynesian cross. The aggregate expenditure line is obtained by adding investment expenditures, government purchases, and net exports to the consumption line. As such, the slope of the aggregate expenditure line is largely based on the slope of the consumption line (which is the marginal propensity to consume), with adjustments coming from the marginal propensity to invest, the marginal propensity for government purchases, and the marginal propensity to import. The intersection of the aggregate expenditures line and the 45-degree line identifies the equilibrium level of output in the Keynesian cross.
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The notion that a competitive market automatically achieves an efficient allocation of resources by equating demand price with supply price and quantity demanded with quantity supplied. Market efficiency relies on the self-correction process that eliminates shortages or surpluses. It also presumes that the market is competitive and is not subject to market failures. Market efficiency is the hallmark of a competitive market. Buyers and sellers, acting in their own best interest, seek a mutually agreeable exchange at a market price that achieves efficiency, given competition and the absence of market failures.
The Efficiency PinnacleThe allocation of resources is efficient if the maximum level of satisfaction is achieved from a given amount of resources. In other words, efficiency means that it is not possible to reallocate resources in any other way that would generate greater satisfaction. It is not possible to increase overall satisfaction by producing more of one good and less of another. With efficiency, the current allocation of resources has reached the top, the peak, the pinnacle of satisfaction.
In terms of the market, efficiency is achieved by the equality between the demand price and the supply price.
Efficiency results with an equality between the demand price and supply price. The value of the good produced is equal to the value of goods not produced. It is not possible to increase value, or satisfaction, by producing more of one good and less of the other.
- Demand Price: The demand price is the maximum price that buyers are willing and able to pay for a good. This price is based on the satisfaction of wants and needs that buyers receive from the good. Demand price is the value of the good produced.
- Supply Price: The supply price is the minimum price that sellers are willing and able to accept for a good. This price is based on the opportunity cost of production, which is the amount of satisfaction given up from goods foregone. Supply price is the value of goods not produced.
To demonstrate why this equality achieves efficiency, consider a hypothetical monetary exchange between Edgar Millbottom and Professor Grumpinkston.
- Option 1: Suppose that Edgar gives the Professor $5 and the Professor gives Edgar $15 in exchange. Edgar is better off after the exchange (by the tune of $10) than before. Because the money given up is less than the money received, Edgar has improved his situation. In the same way, if the supply price (the value of production given up) is less than the demand price (the value of production received), society benefits by exchanging more of the good.
- Option 2: Now suppose that Edgar gives the Professor $15 and the Professor gives Edgar only $5 in exchange. Edgar is worse off after the exchange (also by $10) than before. Because the money given up is greater than the money received, Edgar has worsened his situation. In fact, Edgar can improve his situation by NOT making exchanges such as this. In the same way, if the supply price is greater than the demand price, society benefits by exchanging less of the good.
- Option 3: Finally, suppose that Edgar gives the Professor $10 and the Professor gives Edgar $10 back. Edgar is no better or worse off after then exchange than before. He gives up the same amount that he receives. He cannot improve his situation by making more or fewer exchanges with the Professor. This is comparable to a market exchange with an equality between supply price and demand price. Society receives no extra benefit by exchanging more or less of a good.
Efficiency is achieved in a competitive market at the equilibrium intersection of the demand and supply curves (given that no market failures are present). The exhibit to the right can be used to illustrate an efficient equilibrium. This is the market for 8-track tapes generated by trading activity at the 88th Annual Trackmania 8-Track Tape Collectors Convention at the Shady Valley Exposition Center.
Equilibrium is achieved at a price of 50 cents and a quantity of 400 tapes. Most important, the price buyers are willing and able to pay for 400 tapes (the demand price) is equal to the price sellers are willing and able to accept for 400 tapes (the supply price).
Consider these important points:
Equality between the demand price and the supply price means that the satisfaction obtained from the good produced is equal to the opportunity cost of production. This equality further means that the value of the good that IS produced is equal to the value of goods NOT produced.
- Quantity demanded and quantity supplied are equal. Buyers are able to buy all that they want and sellers are able to sell all that they have. In this graph, buyers are willing to buy 400 tapes and sellers are willing to sell 400 tapes.
- Demand price and supply price are equal. The maximum demand price that buyers are willing and able to pay is equal to the minimum supply price that sellers are willing and able to accept. In this graph, buyers are willing to pay 50 cents per tape and sellers are willing to accept 50 cents per tape.
In this 8-track tape market, society (from the buying side) receives 50 cents worth of value per tape and society (from the selling side) gives up 50 cents of value per tape. As such, the value (that is, satisfaction of wants and needs) society receives from using its resources can NOT be increased by producing more of one good and less of another good. There is no way to increase value by exchanging more or less than 400 tapes. And THAT is efficiency.
More or Less
To illustrate that equilibrium IS efficient, consider alternatives that are not efficient.
- Too Little Production: Suppose the demand price exceeds the supply price in a market with too little production. To illustrate this, click the [Too Little] button. The "too little" quantity revealed is 300 tapes.
The demand price for 300 tapes is 60 cents per tape. This is the value society receives on the buying side from the good produced.
The supply price for 300 tapes is 40 cents per tape. This is the value society gives up on the selling side from goods not produced.
At this quantity of "too little" production, society is getting 60 cents of value per tape and only giving up 40 cents of value per tape. While this seems good, it can be better. Being able to improve the situation is what makes this particular situation inefficient. By exchanging the 301st tape, for example, society receives (just under) 60 cents worth of value and gives up on (just over) 40 cents, a net gain of about 20 cents.
- Too Much Production: The supply price exceeds the demand price in a market with too much production. To illustrate this, click the [Too Much] button. The "too much" quantity revealed is 500 tapes.
The demand price for 500 tapes is 40 cents per tape. This is the value society receives on the buying side from the good produced.
The supply price for 500 tapes is 60 cents per tape. This is the value society gives up on the selling side from goods not produced.
At this quantity of "too much" production, society is receiving 40 cents of value per tape and giving up 60 cents of value per tape. This is obviously not good, and it can be better. Once again, being able to improve the situation is what makes this inefficient. By reducing the exchange to 499 tapes, for example, society gives up (just over) 40 cents by exchanging one fewer tape, but gets (just under) 60 cents worth of value by using resources for other goods. Once again, this is a net gain of about 20 cents.
Market FailuresIn a perfect world, competitive markets automatically achieved efficiency at equilibrium. However, the world is not perfect and efficiency is not always assured through voluntary market exchanges. The primary reason for the lack of market efficiency can be found with four types of market failures--public goods, market control, externalities, and imperfect information. These market failures mean that either: (1) the demand and supply prices do not fully reflect the value of production or (2) the demand and supply prices are not equal.
- Public Goods: These are goods characterized by nonrival consumption and the inability to exclude nonpayers from receiving benefits. Market inefficiency emerges because the demand price that buyers are willing and able to pay is only a small fraction (extremely small fraction) of the total value society receives from the good.
- Market Control: This results due to the lack of competition among either buyers or sellers. Market inefficiency occurs because market control prevents an equality between demand price and supply price.
- Externalities: In this case, buyers and sellers are not the only ones receiving benefits or incurring costs due to the production and exchange of the good. In other words, some benefits or costs are external to the market. Market inefficiency results because the demand price does not reflect the full value received from a good and/or the supply price does not reflect the overall opportunity cost of foregone production.
- Imperfect Information: This means that buyers or sellers do not have complete information about the product being exchanged. As such, the demand or supply prices do not fully reflect the value received or the value foregone from a good. Like externalities, market inefficiency results because the demand and supply prices do not fully reflect the value of production.
MARKET EFFICIENCY, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: March 3, 2024].
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