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6.2: Maximizing in the Marketplace

  • Page ID
    14043
  • Learning Objectives

    1. Explain what is meant by an efficient allocation of resources in an economy and describe the market conditions that must exist to achieve this goal.
    2. Define consumer and producer surplus.
    3. Discuss the relationship between efficiency and equity.

    In perhaps the most influential book in economics ever written, An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776, Adam Smith argued that the pursuit of self-interest in a marketplace would promote the general interest. He said resources would be guided, as if by an “invisible hand,” to their best uses. That invisible hand was the marketplace.

    Smith’s idea was radical for its time; he saw that the seemingly haphazard workings of the marketplace could promote the common good. In this section, we will use the tools we have developed thus far to see the power of Smith’s invisible hand. Efforts by individuals to maximize their own net benefit can maximize net benefit for the economy as a whole.

    When the net benefits of all economic activities are maximized, economists say the allocation of resources is efficient. This concept of efficiency is broader than the notion of efficient production that we encountered when discussing the production possibilities curve. There, we saw that the economy’s factors of production would be efficient in production if they were allocated according to the principle of comparative advantage. That meant producing as much as possible with the factors of production available. The concept of an efficient allocation of resources incorporates production, as in that discussion, but it includes efficiency in the consumption of goods and services as well.

    Achieving Efficiency

    Imagine yourself arriving at the store to purchase some food. In your choice, you will weigh your own benefits and costs to maximize your net benefit. The farmers, the distributors, and the grocer have sought to maximize their net benefits as well. How can we expect that all those efforts will maximize net benefits for the economy as a whole? How can we expect the marketplace to achieve an efficient allocation of food, or of anything else?

    One condition that must be met if the market’s allocation is to be efficient is that the marketplace must be competitive or function as if it were. We will have a great deal more to say about competitive markets versus less competitive ones in subsequent chapters. For now, we can simply note that a competitive market is one with many buyers and sellers in each market and in which entry and exit are fairly easy. No one controls the price; the forces of demand and supply determine price.

    The second condition that must hold if the market is to achieve an efficient allocation concerns property rights. We turn to that topic in the next section.

    The Role of Property Rights

    A smoothly functioning market requires that producers possess property rights to the goods and services they produce and that consumers possess property rights to the goods and services they buy. Property rights are a set of rules that specify the ways in which an owner can use a resource.

    Consider the tomato market. Farmers who grow tomatoes have clearly defined rights to their land and to the tomatoes they produce and sell. Distributors who purchase tomatoes from farmers and sell them to grocers have clear rights to the tomatoes until they sell them to grocers. The grocers who purchase the tomatoes retain rights to them until they sell them to consumers. When you buy a tomato, you have the exclusive right to its use.

    A system of property rights forms the basis for all market exchange. Before exchange can begin, there must be a clear specification of who owns what. The system of property rights must also show what purchasers are acquiring when they buy rights to particular resources. Because property rights must exist if exchange is to occur, and because exchange is the process through which economic efficiency is achieved, a system of property rights is essential to the efficient allocation of resources.

    Imagine what would happen in the market for tomatoes if property rights were not clearly defined. Suppose, for example, that grocers could not legally prevent someone from simply grabbing some tomatoes and leaving without paying for them. If that were the case, grocers would not be likely to offer tomatoes for sale. If it were the case for all grocery items, there would not be grocery stores at all.

    Although property rights vary for different resources, two characteristics are required if the marketplace is to achieve an efficient allocation of resources:

    1. Property rights must be exclusive. An exclusive property right is one that allows its owner to prevent others from using the resource. The owner of a house, for example, has the right to exclude others from the use of the house. If this right did not exist, ownership would have little value; it is not likely that the property could be exchanged in a market. And the inability to sell property would limit the incentive of owners to maintain it.
    2. Property rights must be transferable. A transferable property right is one that allows the owner of a resource to sell or lease it to someone else. In the absence of transferability, no exchange could occur.

    Markets and the Efficiency Condition

    A competitive market with well-defined and transferable property rights satisfies the efficiency condition. If met, we can assume that the market’s allocation of resources will be efficient.

    Consider again your purchase of tomatoes. Suppose the curves of demand and supply for tomatoes are those given in Figure 6.10 “Demand and Supply and the Efficiency Condition”; the equilibrium price equals $1.50 per pound. Suppose further that the market satisfies the efficiency condition. With that assumption, we can relate the model of demand and supply to our analysis of marginal benefits and costs.

    Figure 6.10 Demand and Supply and the Efficiency Condition

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    In a competitive market with exclusive and transferable property rights, such as the market for tomatoes, the efficiency condition is met. Buyers and sellers are faced with all of the relevant benefits and costs, and the equilibrium price equals the marginal cost to society of producing that good, here $2.50 per pound. We can interpret the market demand and supply curve as marginal benefit and marginal cost curves, respectively.

    The demand curve tells us that the last pound of tomatoes was worth $1.50; we can think of that as the marginal benefit of the last pound of tomatoes since that is how much consumers were willing to pay. We can say that about any price on a market demand curve; a demand curve can be considered as a marginal benefit curve. Similarly, the supply curve can be considered the marginal cost curve. In the case of the tomato market, for example, the price tells us that the marginal cost of producing the last pound of tomatoes is $1.50. This marginal cost is considered in the economic sense—other goods and services worth $1.50 were not produced in order to make an additional pound of tomatoes available.

    On what basis can we presume that the price of a pound of tomatoes equals its marginal cost? The answer lies in our marginal decision rule. Profit-maximizing tomato producers will produce more tomatoes as long as their marginal benefit exceeds their marginal cost. What is the marginal benefit to a producer of an extra pound of tomatoes? It is the price that the producer will receive. What is the marginal cost? It is the value that must be given up to produce an extra pound of tomatoes.

    Producers maximize profit by expanding their production up to the point at which their marginal cost equals their marginal benefit, which is the market price. The price of $1.50 thus reflects the marginal cost to society of making an additional pound of tomatoes available.

    At the equilibrium price and output of tomatoes, then, the marginal benefit of tomatoes to consumers, as reflected by the price they are willing to pay, equals the marginal cost of producing tomatoes. Where marginal benefit equals marginal cost, net benefit is maximized. The equilibrium quantity of tomatoes, as determined by demand and supply, is efficient.