Question

Understand that efficiency is a situation in which people do the best they can, given their limited resources. A market equilibrium will generate the largest possible surplus and be efficient if the certain conditions are met. List and define these conditions.

a.         No external benefits -

b.         No external costs -

c.         Perfect information

d.         Perfect competition

Answer 1

a) No external benefit implies that a market transaction will not give any benefit to the bystanders. If any transaction gives benefit to a bystander, then the social benefit becomes greater than the private benefit and the market cannot account for this benefit. Thus market fails and becomes inefficient. No external benefit implies marginal social benefit = marginal private benefit.

b) No external cost implies that a market transaction will affect negatively its bystanders. If any transaction imposes additional cost to a bystander, then the social cost becomes greater than the private cost and the market cannot account for this cost. Thus market fails and becomes inefficient. No external cost implies marginal social cost = marginal private cost.

c) Perfect information means that every party involved in the transaction have complete knowledge about the transaction. If one party has more knowledge, market fails to function efficiently to allocate scarce resources.

d) In perfect competition, there is free entry-exit, a large number of firms and homogeneous product. Thus, no firm has market power. No individual consumer or producer has any ability to influence market price. Thus, market gives efficient outcome.