Question

Explain why economists believe that in standard markets the equilibrium is e?cient, and welfare is maximised. Use and describe the fundamental assumptions and laws of economics.

Answer 1

Economists believe that in standard markets, the equilibrium level of is at an efficient point and also at a point that maximizes welfare. This definition of efficiency addresses the concept of ‘allocative efficiency’. In our economy, resources are scarce and limited and the equilibrium point of standard markets results in the most efficient allocation of scarce resources that result in maximum welfare.

To put it simply, efficiency deals with ‘How much one can produce’ and when the level of production is maximized, economic efficiency is said to be maximum.

Strictly in an economic term, welfare refers to the total of consumer’s surplus and producer’s surplus that is available in the economy. Fig 1 represents the forces of demand and supply in a standard market. In a standard market, the most important assumption is that of the ‘invisible hand’ where any deviation from the point of equilibrium is self-corrected by changes in the market forces of demand and supply, only to restore equilibrium again. There is absolutely NO outside intervention and whichever changes occur in the market are solely due to the interaction of forces of demand and supply.

In the figure, the downward sloping demand curve (D) intersects the upward sloping supply curve (S) at point E. The equilibrium level of output is Q* and the equilibrium level of price is P*. The consumer’s surplus (CS) is given by the area of the triangle AEP* which is below the demand curve and above the price. The producer’s surplus (PS) is given by the area of the triangle BEP* which is above the supply curve and below the price. Individually, the CS and PS are both maximized at price P* and Quantity Q*. Thus, welfare is also maximized at the equilibrium outcome of standard markets. Any deviation from price away from the equilibrium level of price, REDUCES the area of the consumer’s surplus and producer’s surplus and sometimes even results in a deadweight loss, which is a net loss to the society. This is clear from Fig A which is a deviation from the assumptions of a standard market. The price after tax is forcefully kept above the equilibrium market price of $80. Thus, CS reduces from the efficient level of triangle ABC to triangle AB’C’, PS from triangle DBC to DEE’. While the quadrilateral C’E’EB’ represents government revenue from tax, the triangle CEC’ represents deadweight loss to the society and overall welfare reduces and there is a loss of efficiency as the market outcome becomes inefficient. This is because, in the absence of taxes, the quantity would’ve been 240 units, but in the presence of taxes, the quantity reduces to 120 units. Thus, much more COULD’VE BEEN PRODUCED in the presence of standard markets. This deadweight loss vanishes as soon as the price goes down to the equilibrium level of price, validating the claim that in standard markets, welfare is maximized and allocations are efficient.

It is very important to remember that ‘standard markets’ as the name itself suggests is a ‘standard’ or a ‘benchmark’ in the ideal world, that is used to study other types of markets existing in the real world. There are a host of assumptions that work behind the success of the invisible hands. Some of the fundamental assumptions of economics are as follows:

(i) Every agent is rational and looks out for his or her benefit in the economy.

(ii) The sole motive of a rational consumer is to maximize utility and the sole motive of a rational producer is to maximize profit.

(iii) There is perfect knowledge in the market where each buyer and seller knows everything about the product or service under question and makes completely informed decisions.

(iv) There are no transaction costs in the economy that prevents a bargain from taking place to reach the most efficient solution in the presence of externalities.

(v) Lastly, the most important assumption that makes economics stand as a subject is that, resources in the economy are limited and our wants are unlimited. Therefore, it is imperative to allocate those scarce resources to satisfy human wants. This can be done by addressing the questions;

1. What to produce?
2. How to produce?
3. And for whom to produce?

While it is true that other assumptions also play a pivotal role in the economy’s functioning, the basic assumptions and laws are the ones that have been stated above.