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Are you an efficient learner? Can you grasp concepts quickly and go to the next step of applying them straight away? In another case, someone may need to go into all the little details to understand how something works. Well, we are all different. Regardless of your answer, market efficiency in economics is distinct from how you are possibly used to thinking about the word. Don't worry; we are here to help you understand market efficiency with the utmost proficiency! No pun intended. You will have to stick around for a little longer, though! If you are ready, then let's get started!
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Jetzt kostenlos anmeldenAre you an efficient learner? Can you grasp concepts quickly and go to the next step of applying them straight away? In another case, someone may need to go into all the little details to understand how something works. Well, we are all different. Regardless of your answer, market efficiency in economics is distinct from how you are possibly used to thinking about the word. Don't worry; we are here to help you understand market efficiency with the utmost proficiency! No pun intended. You will have to stick around for a little longer, though! If you are ready, then let's get started!
Let's start comprehending the idea of market efficiency by comparing and contrasting a simple market equilibrium vs. an efficient equilibrium. Standard market equilibrium occurs when supply is equal to demand at a specific price. An efficient market equilibrium is best described by looking at a perfectly competitive market. This will be our benchmark for defining an efficient market equilibrium.Consider a perfectly competitive unregulated market with perfect information and externalities nonexistent. Of course, all the conditions for a perfectly competitive market should hold. Then the market equilibrium will look like the one in Figure 1 below.
Need more certainty about the conditions that have to hold for a perfectly competitive market?We've got you covered!Check out this article:- Perfectly Competitive Market.
Fig. 1 - Efficient market equilibrium
Figure 1 above shows an efficient equilibrium in a perfectly competitive market. At price P and quantity Q, equilibrium occurs such that both the producer surplus, represented by the yellow area, and the Consumer Surplus, represented by the triangle shaded in purple, are maximized. This shows a market that has achieved economic efficiency.
Market or economic efficiency occurs when producer and consumer surpluses are maximized.
Imagine now that a government implements price controls through a price ceiling. The goal that the government has in mind is to help increase consumer welfare by lowering prices. What would the consequences of such a decision be for market efficiency? Let's take a look at Figure 2 below.
Fig. 2 - Effect of price control on market efficiency
Figure 2 above shows the effect of price control on market efficiency. The initial equilibrium was at the intersection of the demand and supply curves at price P and quantity Q. However, after the suppliers had to lower their prices due to the imposed price ceiling at P1, a deadweight loss occurred. Wait, wasn't the price ceiling supposed to improve the well-being of the consumers in this market?
Deadweight loss is a net loss of producer and Consumer Surplus in a market due to inefficiency.
Although some consumers benefitted from lower prices, others did little. At a lower price of P1, more consumers are willing to buy the product, resulting in a market shortage. The deadweight loss (DWL) illustrated by the triangle shaded in red occurs due to this reduction in quantity. Government intervention resulted in reduced market efficiency in this case. In the aggregate, producers plus consumers are worse off than they were without government intervention.
Did we get you interested in these topics?We have more waiting for you, so check out the following:- Price Ceilings;- Price Floors.
Let's go over some examples of market efficiency to sharpen our understanding.
We will consider the effects of the following government interventions on market efficiency:
Tax;
Subsidy.
Imagine the government introducing a tax in the market. The effects of the tax are illustrated in Figure 3 below.
Fig. 3 - Tax effect on market efficiency
Figure 3 above shows the market's initial equilibrium, where the supply and demand curves intersect. A government tax results in consumers paying a higher price (P2 compared to Pe) and producers receiving a lower price (P1 compared to Pe). A lower quantity is now exchanged in the market (Q2 compared to Qe). Consumer and producer surplus both reduce at the expense of the tax revenue, shaded in green, that goes to the government. But that is not the end of the story. Due to a reduction in quantity from Qe to Q2, a deadweight loss (DWL) occurs. A tax introduced by the government led to a reduction in overall market efficiency.
Let's consider the effect a government subsidy would have on market efficiency. The results of the subsidy are illustrated in Figure 4 below.
Fig. 4 - Subsidy effect on market efficiency
Figure 4 above depicts a subsidy provided by the government which increases the corresponding consumer surplus, shown by the area highlighted in purple, and producer surplus, shown by the area highlighted in yellow. The increase in producer surplus results from an increase in the price they receive for their product (P3 compared to Pe). An expansion of consumer surplus comes from the lower price they pay for the product (P2 compared to Pe). It seems like the subsidy intervention had increased market efficiency in this case. Yes and no. Although both consumer and producer surplus increased, a more significant improvement in market efficiency could have been attained at the higher quantity (Q2 compared to Qe) now exchanged in the market. The deadweight loss triangle highlighted in red shows that not all of the efficiency was attained.
Discover more in our article - Taxes and Subsidies!
What is the difference between market efficiency vs. market failure? Market efficiency is the opposite of market failure. If the market is fully efficient, then there is no market failure. In contrast, if a market loses some of its efficiency, the degree of market failure increases.
Market failure occurs when the price mechanism fails to provide correct signals to producers and consumers, resulting in inefficient resource allocation.
There are two major contributors to market failure:
Externalities;
Incorrect types or a lack of information.
Let's take a look at each of these in turn!
What effect do externalities have on market efficiency? Externalities occur when unintended consequences have spillover effects on other parties outside of a transaction mechanism.Externalities result in market failure due to a deadweight loss that they bring. Consider Figure 5 below.
Fig. 5 - Externality and market efficiency
Figure 5 above shows how a Negative Externality causes a welfare loss and a decrease in market efficiency due to pollution. The market is initially at a point where the marginal private cost curve (S0=MPC) intersects the Demand Curve (D). For simplicity, we assume that the marginal private benefit is equal to the marginal social benefit and equal to demand (MPB=MSB=D).The pollution is too high at price P0 and quantity Q0 because the higher cost to society, or the spillover effect, is ignored. This results in a deadweight loss, shown by the red triangle DWL.The government can intervene to reduce this welfare loss and improve market efficiency by introducing a tax on the producer. A surcharge will shift the supply curve from S0 to Stax, bringing the marginal private cost (MPC) to the marginal social cost (MSC). The quantity of pollution, therefore, drops from Q0 to Qtax eliminating deadweight loss and improving market efficiency.
Learn more in our article - Externalities!
Externalities occur when unintended consequences have spillover effects on other parties outside of a transaction mechanism.
What effect do the different types of information have on market efficiency?
A lack of information or incorrect types of information can result in decreased market efficiency.
Perfect information occurs when consumers and producers have access to all the available information relevant to the market transaction.
When information is not perfect, something economists call 'imperfect information,' market efficiency is reduced, and market failure can occur.In a situation of Adverse Selection, where the buyer does not have sufficient information about the product, they may be misled into buying a substandard quality product at a price higher than their willingness to pay. This would result in a decreased consumer surplus for the buyer and a reduction in overall market efficiency.
Dive deeper into these topics by clicking here:- Adverse Selection;- Asymmetric Information.
Market efficiency in finance is different from market efficiency in economics. Market efficiency in finance refers to the asset market prices correctly conveying the information about the returns that these assets can generate. Because prices reflect all the available information, no investor can generate an excess return by predicting where the asset price will move. This is at the core of the Efficient Market Hypothesis first stipulated by Eugene Fama in the 1960s.
We've got you covered in the area of finance too!Make sure to check out the following articles:- Financial Economics;- Security Market Line;- Efficient Market Hypothesis.
Market or economic efficiency occurs when producer and consumer surpluses are maximized.
Market failure occurs when the price mechanism fails to provide correct signals to producers and consumers, resulting in inefficient resource allocation.
There are two major types of market failure:
1. Market failure resulting from externalities;
2. Market failure due to a lack of information.
The importance of market efficiency results from the fact that both consumer and producer surpluses are maximized. In other words, given the unregulated free market, the price and quantity of the product sold are such that consumer and producer welfare are both maximized.
The characteristics of an efficient market are the same as those of a hypothetical perfectly competitive market.
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SIGNUP SIGNUPFlashcards in Market Efficiency944
Start learningDefine government intervention.
Government intervention is when a government is involved in the marketplace.
Why do governments intervene in the marketplace?
To overcome market failure.
What are the types of government intervention?
Taxes
Subsidies
Minimum and maximum prices
Regulations
What are subsidies?
Subsidies are financial support to products with positive externalities.
What are minimum prices?
Setting a lower limit for prices by the government.
What are the disadvantages of setting minimum prices?
It can be costly for the government and force it to put tariffs on cheap imports – which damages the welfare of farmers in other countries.
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