MARKET MAXIMIZATION AND EFFICIENCY

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Post by modi on Sun Oct 27, 2013 1:16 pm

MARKET MAXIMIZATION AND EFFICIENCY
 
In the earlier Introduction to Economics section, economic choices and decision making were discussed in terms of the benefits and cost of choices or tradeoffs.  Economics teaches us that choices should be made which maximize or result in the greatest “net” benefits received.  You may recall that net benefits = benefits less costs.
 
MAXIMIZING BEHAVIOR
 
To maximize net benefits, we must first know the marginal benefits and marginal costs
 
for each choice.  Marginal in this context refers to the increase (or decrease) in benefits
 
and costs that result from consuming or producing 1 more unit of a product.
 
 
Marginal Decision Rule
 
This is a very important decision making rule that ensures that net benefits are maximized in
 
making choices.  This rule is shown below with MB = marginal benefit and MC = marginal
 
cost.
 
        1).  If the MB of an additional unit of activity > its MC, the additional unit should be
chosen.
 
        2).  If the MB of an additional unit of activity < its MC, the additional unit should not be
chosen.
 
        3).  When the MB of an additional unit of activity = its MC, the additional unit will result in
the maximization of (total) net benefits.  Additional or less units chosen from this
levelwill reduce the total and net benefits.
 
   Hence, according to the marginal decision rule, the total “net” benefits from choices are
 
maximized where MB = MC.  An understanding of this important concept is critical to
 
understanding microeconomics. 
 
 
APPLICATION TO MARKETS
 
The marginal benefit curve is equivalent to the demand curve in markets.  The area lying under
 
the market demand curve represents the total benefits consumers receive.   The marginal cost
 
curve is equivalent to the supply curve in markets.  The area lying below the market supply
 
curve represents the total cost incurred by seller (producers).
 
 
Market Maximization
 
In markets, net benefits are maximized at the level of activity where the demand (MB) and
supply (MC) curves intersect (equilibrium).  At this point, MB = MC and, therefore, according
tothe marginal decision making rule, total net benefits are maximized.  This equilibrium
representsallocative efficiency which means that economic resources are being used to   
produce the quantity of products at a price that “both” buyers and sellers are satisfied with. 
When all markets are in equilibrium and net benefits are maximized, the economy is said to
have reached allocative efficiency. If a market or markets are not in equilibrium, a “dead-
weight loss is created which means that the total net benefits are not maximized, i.e. MB is >
MC or MB< than MC.
 
 
Consumer Surplus
 
·         Refers to the net benefit consumers receive from purchasing and consuming a product.
·   Equal to the amount by which consumer total benefits from consuming a product exceed the expenditures they made to purchase the product.
 
Producer Surplus
 
·          The net benefit producers (sellers) receive from producing and supply a product.
        ·    Equal to the amount by which a seller’s total revenue exceed its total cost for a product.
 
   Note:  consumer surplus + producer surplus = total net benefits in a market.  This net benefit
and hence consumer and producer surpluses are maximized at market equilibrium
             (where MB = MC).  If this condition does not exist, a dead-weight loss occurs.
            (see the graphs below)
 
 
 
 
 
 
 
 
 
CONSUMER AND PRODUCER SURPLUS GRAPH
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                         DEAD-WEIGHT LOSSES GRAPHS
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Efficiency Conditions
 
For markets to achieve maximization of net benefits, the following two conditions must be met.
 
   1).   The market must be competitive.
 
   2).  Property tights must exist and be exclusive and transferable.
 
 
PROBLEMS IN ACHIEVING EFFICIENCY 
 
Markets don’t always result in the best or optimal outcomes even if the above efficiency
 
conditions are satisfied.  Markets are not perfect; they often have imperfections that are called
 
market failures.  Market failures will be discussed later in the section on the government sector.
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