Efficient Market Hypothesis and Evidence of Market Efficiency

Describe the efficient market hypothesis and give a piece of evidence consistent with this theory.
Markets operate efficiently when resources are fully employed and output is produced at lowest possible costs at quantities that correspond to rational consumer behavior. Market efficiency involves both productive and allocative efficiency.

Productive efficiency is concerned with quantity of goods and services produced. It is achieved when it is impossible to increase output of one type of product without reducing the output of another product i.e. all resources are fully employed and the economy is operating on its production possibility curve. Allocative efficiency is achieved when the resources are allocated in the right proportions to produce different goods and services to give a product mix that reflects consumers’ preferences. (Grant, 2003)

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The term ‘efficient’ as used by economists simply means, ‘If price and quantity take anything other than their equilibrium values, a transaction that will make at least some people better off without harming others can always be found.’(Frank and Bernanke, 2001)  This is known as Pareto efficiency, named after the Italian economist, Vilfredo Pareto. It is a state whereby there is no way of making one party in a market better off without making the other party worse off. It is achieved when productive and allocative efficiency interacts.

An efficient transaction creates an economic surplus. If a product sells below the market equilibrium price, it is not efficient.

2. The cleaning service firm Clean All plc increased its workers wages by 4% and it experienced an increase in its profits. How can this have happened?

Increasing wages boosts workers’ productivity. Workers are also tempted to work for longer hours which also increase productivity. This results in higher profits and labor turnover is also significantly lowered. Even though wages are higher, the firm may not have significantly higher labor costs per unit of output.

An employer’s reservation price for a worker is the most the employer could pay without suffering a decline in profit. In a perfectly competitive labor market, this price is the value of worker’s marginal product (VMP).

A worker’s marginal product is the extra output the firm gets as a result of hiring that worker. Value marginal product is the net contribution the worker makes to the employer’s revenue i.e. result of multiplying the worker’s marginal product by the net price for which each unit of product sells.

By reason of the law of diminishing returns, we know that the marginal product of labor, hence VMP, declines in the short run as the quantity of labor rises.

The individual employer’s demand curve for labor, in this case Clean All plc may be shown as downward sloping function of wage rate. The supply curve of labor for any particular occupation is upward sloping.

3) Does on increase in saving lead to a higher standard of living? Why? Might a politician prefer not to try to introduce resources increase at the rate of saving?

Yes, savings lead to higher standard of living. Savings are that part of current income that is not spent on current needs .Higher rates of saving today leads to faster accumulation of wealth and the wealthier an economic unit is (e.g. household or nation) the higher its standard of living in the future.

Savings are mostly employed in financial investments e.g. government bonds or shares of stock in a corporation. These pay returns in form of interest payments, dividends or capital gains High returns are desirable of course  because the higher the return the faster ones savings grow.

The rate of return most relevant is savings decision is the real interest rate i.e. the rate at which the real purchasing power of a financial asset increases over time .it is the market nominal interest rate minus the inflation rate. The real interest rate is relevant to savers because it is reward for savings. Empirical evidence suggests that higher real interest rates lead to increases in savings (Frank and Benanke, 2001).

Politicians tend to benefit e.g. by gaining political mileage when the economy is favorable, thus they tend to exert a strong bias toward expansionary policy. What prevents politicians from implementing the expansionary policies is inflation at least to fear of generating on acceleration inflation. Inflation is a continuous rise in price level measured with price indexes. If money supply rises the price level will also rise. Inflation does not promote a favorable political environment.

References

Bernanke, B. and Frank, R. (2001): Principles of Economics .New York: McGraw-Hill

Colander, D.C (2001): Economics, New York: McGraw Hill Companies.

Eaton, B., Diane F. and Douglas W. (2002): Microeconomics.5th Edition: New York,

Prentice Hall

Mankiw, N. (2000): Principles of Microeconomics. London, South-Western Pub

Prentice Ha Grant, S. J. (2003): Stan Lake’s Introduction Economics, 7th Edition. Harlow:

Pearson’s Education ltd

Ruffin, R. and Paul R. (2000): Principles of Microeconomics. New York, Addison

Wesley

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