Efficient Output

We will find that the supply-and-demand equilibrium is efficient in other ways as well.

Suppose we ask ourselves: how many machines (of a specific kind) would it be efficient to produce?

Define "net benefits" as "benefits minus costs." One concept of "efficient output" is "the output that maximizes the net benefit from machines." That is the concept of efficiency we will use. It is approximative, of course -- since "benefits" and "costs" are money approximations to nonmonetary utility and opportunity costs -- but it will give the right answers all the same.

Net Benefits

The idea is that net benefits will first increase, as machine output increases, and then decline again, as shown in the figure above.

Here is the Production Possibility Frontier for This Example:

Here it is in Tabular Form:

Table 1
machines food
0 1000
100 990
200 960
300 910
400 840
500 750
600 640
700 510
800 360
900 190
1000 0

Figure 3. Total Cost of Machine Production

Marginal Cost Table

Machines Marginal
Cost
0
.10
100
.30
200
.50
300
.70
400
.90
500
1.10
600
1.30
700
1.50
800
1.70
900
1.90
1000

Figure 4. Marginal Cost of Machines

Table 3. Total Benefit of Machine Production

machines benefits
0 0
100 220
200 420
300 600
400 760
500 900
600 1020
700 1120
800 1200
900 1260
1000 1300

Marginal Benefit

Machines Marginal
Benefit
0
2.20
100
2.00
200
1.80
300
1.60
400
1.40
500
1.20
600
1.00
700
0.80
800
0.60
900
0.40
1000

Figure 5. Marginal Benefit

Maximizing Net Benefits

It will come as no surprise, I suspect, that the rule for "maximum net benefit" is "set output so that marginal cost is equal to marginal benefit."

In the diagram, the dark line is marginal benefits, the vertical-dashed line is marginal costs, and the optimum output is 575.

Equilibrium and Efficiency

But now we recall that, in a P-competitive market, demand is the same as marginal benefit and supply is the same as marginal cost. So to say that quantity supplied equals quantity demanded is to say that marginal benefit equals marginal cost -- ideally!

This leads to what I call the "fundamental principle of microeconomics:"

If All goods, services and resources are paid for by those who benefit from them, and

the payment is at P-Competitive equilibrium prices,

then

output quantities are efficient.

Exceptions

Sounds pretty good, right? And it is -- it is a remarkable insight about the power of price competition to promote efficiency. However -- it is not the whole story, of course.

There are at least two ways inefficiency can creep into the market anyway.

First, markets may not be P-Competitive, and prices and outputs may deviate from the P-competitive norm.

Second, people may not pay for the goods, services, and resources they use. for example, in Equador, the loggers pollute water and thus destroy the businesses of the fish-farmers downstream. The loggers are using a resource they do not pay for -- fresh water -- and thus depriving the fish-farmers of it, even though (probably) the fish-farmers can make more effective use of it.

Finally, even if the P-Competitive equilibrium is efficient, there may be other objectives besides efficiency. For example, efficiency can coexist with great inequality. A slave economy could be efficient.

Nevertheless, the ideal P-Competitive economy stands as an ideal in which rational self-interest leads to an efficient allocation of resources -- a remarkable modern reflection of Adam Smith's founding insight.