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!
Market equilibrium vs. efficient equilibrium
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.
Market efficiency examples
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:
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