Dec 08 2010

Why Greed is Good (or how in pursuit of their own self-interest firms do what’s best for society)

Published by at 7:31 pm under Efficiency,Perfect competition

Efficiency means more than just producing in the least cost manner. To be efficient a market must also allocate the right amount of resources towards the production of the good or service it provides. Allocative efficiency occurs when land, labor and capital are allocated towards the production of goods and services in combinations that are socially optimal. In other words, the right amount of output of various products is being produced given the demands of consumers in the economy and the costs faced by firms.

Because of firms’ profit maximizing behavior, perfectly competitive markets allocate resources efficiently, neither over nor under-producing the goods consumers demand.

Allocative Efficiency: P=MC

Under the conditions of perfect competition, a market will be allocatively efficient as long as the firms in that market produce at the P=MC level of output. Price is a signal from buyers to sellers, and the price seen by firms signals the marginal benefit of consumers in the market. If the price consumers pay for a product is greater than the marginal cost to firms of producing it, then the message being sent to producers is that more output is demanded. In the pursuit of profits, more resources will be allocated towards the production of the product until the marginal cost and the price are equal. At the P=MC point firms maximize their profits and resources are said to be efficiently allocated.

Graph: Profit maximizing behavior leads to allocative efficiency

Assume that the firm on the right represents the typical firm in a perfectly competitive market. When firms produce at Q1 level of output, resources are under-allocated towards this good, since the price consumers are willing to pay (Pe, determined by market supply and demand) is greater than firms’ marginal cost of production. Notice that when individual firms produce Q1 units, the market supply of Qs is less than the market demand of Qd; there is a shortage in the industry as long as firms produce only Q1 units.

However, firms are unlikely to produce at this socially undesirable level for long because in their pursuit of profits they will increase their output to the quantity at which marginal cost equals the price. When they increase their output to Qf, firms maximize their profits and as a result the shortage in the market that existed when firms produced at Q1 is eliminated, improving social welfare and maximizing the total amount of consumer and producer surplus (the combined areas of the pink and green triangles in the industry graph).

Because of the profit maximizing behavior of self-interested business managers in the competitive market above, resources are more efficiently allocated than they would be otherwise. The price determined by supply and demand in the market signals the benefit society derives from this good, and as long as the price is greater than the marginal cost, the message sent from buyers to seller is “WE WANT MORE!” On the other hand, if at a given level of output marginal cost exceeds the price, resources are over-allocated towards the good. The message sent in such a market is that consumers value the product less than it costs firms to produce, so firms will reduce their output to maximize profits, correcting the over-allocation of resources and restoring a socially optimal level of output.

Allocative efficiency is achieved in a perfectly competitive market precisely because firms will always wish to maximize their profits by producing the quantity of goods at which their marginal cost equals the price.

The article Farmers May Switch Crops Due to Labor Shortage discusses some the effects of rising costs on a perfectly competitive market. Read the extract below and answer the questions that follow.

Farmers may change their crops due to the shortage of immigrant labor. Of all crops, fresh fruits and vegetables are the most labor intensive. Lettuce, strawberries and broccoli all have to be picked by hand. In Arizona, farmers are passing on chili peppers to plant corn, which is harvested by machine.

After 37 years, Ed Curry is not planting green chili anymore because corn can be harvested by machines; green chili can’t.

Curry explains, “It would take about 250 people to pick this year’s chili crop. With immigration tightened up the way it is, well, number one, we just can’t get the labor.”

About seven years ago, Ed Curry was busted for using illegal labor. Today his workers are legal. They go back and forth from Mexico each day, making seven to $8 an hour. Most are in their 50s and 60s. One man is 72 years old. Younger workers can’t get visas or don’t want the jobs. So as his workers age and his workforce dwindles, Ed Curry says he’s thinking about moving some of his operation to Mexico.

“We’re down to survival. Am I going to stay in this or not? And if I’m going to stay in it, I’ve got to do it where there’s plenty of labor and we can be competitive.”

That’s one farmer’s plight. The Western Growers Association based in California represents 3,000 farmers across the region. Its president, Tom Nassif, says farmers need Congress to pass legislation that will allow more workers in, something he says it should have done already.

Nassif says his association polled a dozen members and found more than 40,000 acres had moved to Mexico in the last year or so.

Exercise:

  1. Assuming the market for chili peppers is perfectly competitive, illustrate the effects of the shortage of immigrant workers on the short-run production costs and profits of chili farmers in the American Southwest.
  2. Based on your answer to #1, explain how the chili market will evolve in the long-run in response to the shortage of immigrant workers. How will the market for corn and other capital-intensive agricultural commodities be affected?
  3. Assume the US chili pepper market reaches a new long-run equilibrium following the shortage of immigrant labor. Now demand for chili peppers increases. Use a diagram to illustrate how the profit maximizing behavior of chili pepper farmers assures that there will not be a shortage of chili peppers following the increase in consumers’ demand.

Discussion Questions: In their pursuit of economic profits, firms in a competitive market will, through their collective pursuit of self-interest, inadvertently achieve an allocation of society’s scarce resources that is socially optimal.

  1. Discuss the view that allocative efficiency as defined in this chapter is a socially desirable outcome.
  2. Is it accurate to say that goodness can be achieved through greediness in a market economic system?

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

10 responses so far

10 Responses to “Why Greed is Good (or how in pursuit of their own self-interest firms do what’s best for society)”

  1. Lenna Bodaon 30 Nov 1999 at 1:00 am

    Thanks for the update, Eric! I haven’t had to withdraw RMB via my USD BofA account in a long time so can anyone else confirm these new limits?

  2. Blair T.on 13 Dec 2010 at 9:49 am

    After reading this I guess I am a bit confused. So in the equation P=MC , does P represent price and MC represent Market consumption? Because to me that seems to make more sense. But I guess I am just a bit confused on what they represent but with the things that you stated it seems to make sense that way. So in this blog post are you trying to show us that even though the price may be relatively more than it costs to make the product it's a good thing. What I got out of this article was that in order for the market to run smoothly we need to be efficient. The price of a good needs to be more than the cost of production it takes to make it in order for the company or the producers to make a profit. Because otherwise everything would just go into production and that wouldn't be good , because there would be no money to pay people with or to keep the company really functioning, right? But I guess I am wondering how we reach the point of perfect production? Like is it just in the hands of the producers or do other things in the economy factor into it? because otherwise it seems like the producers can control it pretty smoothly.

  3. Faizan. Q (fizzy)on 13 Dec 2010 at 12:37 pm

    In the situation of allocating the resources, it is appeared to not be socially desirable. This can be seen as Mr. Ed Curry gets in trouble for his illegal ways to maximize his profits. In addition, in our economy there is almost no chance to achieve a perfectly competitiveness industries due to laws and regulations. For example, when there is minimum or maximum price binding of a certain good, then the price of that good is not equivalent to the marginal cost. This allows me to answer yes to whether goodness can be achieved through greediness in different market systems. The reason for that is because when we live in this controlled society, there is lack of efficiency due to the inability to receive the most benefits. But do the advantages for restricted prices outweigh the problems for not meeting the marginal cost? Surely a farmer takes alternatives in price changes by not producing certain goods but that’s not possible for many other industries. This is why we need to allow the self-adjusting process to occur for our economy because the prices are naturally able to meet the marginal costs.

  4. Schutzkuson 14 Dec 2010 at 8:12 am

    It only makes sense that efficiency doesn't only include the price, but the demand for that good as well. Allocative efficiency is probably the best outcome here, because it is the most efficient. Businesses and companies need to know how much of a good to make, and this seems to be an effective way of letting them know whether to produce more or less of a good. As for the idea that goodness can be achieved through greediness, what we ultimately want to achieve is the equilibrium of price and product and demand. Though the higher the demand for a product, usually the better, especially if it is an being supplied at the correct rate to be efficient

  5. Matt Riceon 14 Dec 2010 at 9:40 am

    Once again, we see the importance of prices. As prices help guide the market to its equilibrium, allocative efficiency is made possible and is surely desirable, because a market will be producing the right amount of product, at the right price when it is said to be allocatively efficient. Furthermore, it can definitely be stated that goodness can be achieved through greediness in a market economic system. Quite oppositely, it can be argued that it is quite hard to achieve desirable market economic outcomes without greed. When people are greedy, they want more of something, whether it be money, or some kind of product. One way this can be achieved is by becoming "better" at whatever you do. As a rising tide of greedy people do their best to obtain more, a sense of competition is created –> creating such competition makes winners and losers and ultimately is a form of "creative destruction," only allowing the most greedy/talented workers to stick around. Ultimately the most efficient group of workers is left and the others who were not able to "keep up" are faced with the challenge of finding other things they are capable of doing; however in these cases the good always tends to outweigh the bad, meaning the newfound efficiency of the market outweighs the jobs lost in the process.

  6. Schutzkuson 14 Dec 2010 at 9:53 am

    overall i think this will make aggregate demand go up……

    MS ^ –> interest rates v —-> I ^ —-> AD ^

    please correct me if i'm wrong Jason !

    Yo mamma's so fat, when she went to the beach, the whales sang "We are family!"

  7. Gordon Gekko (Mark)on 14 Dec 2010 at 10:03 am

    Greed, my friends, will always prevail in making decisions that will do what is best for society. You see, greed always puts yourself before others. It makes you or a company, want to make the most profit it can possibly make. Companies want to minimize the input to a point that also maximizes output. This is also taken into effect for the prices, due to the greed of companies, they want to charge the maximum amount that one would pay, to maximize the profits. This is how prices set themselves. A market will produce the right amount of a product, at the right price, at the right time, in order to maximize profit! This is not only good for the company, but it is also good for America. In our economy we strive to have a trade surplus, a situation where we export more than we import, and greed in companies helps this. Companies want to input less (less imports) to maximize the output (GDP and exports). Without greed the world would not agree to free trade if even trade at all. People trade out of self interest. They want to get more for what they trade. In free trade there are winners and losers. People don't like losing. Greed is what runs companies to be the best, greed is what keeps the world turning.

    In the words of myself in the 1987 film, "Wall Street" , The point is, ladies and gentleman, that greed, for lack of a better word, is good. Greed is right, greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all of its forms; greed for life, for money, for love, knowledge has marked the upward surge of mankind. And greed, you mark my words, will not only save Teldar Paper, but that other malfunctioning corporation called the USA. Thank you very much.

  8. Lucyon 14 Dec 2010 at 10:49 am

    1. Allocative efficiency is desirable because it benefits both consumers and producers. When resources are efficiently allocated, firms are making the maximum possible profit while consumers are ensured as much of the product as they want. However, such allocative efficiency could sometimes be negative. For instance, it can result in higher prices, which consumers obviously don't enjoy.

    2. Viewing it in terms of only what propels the economy forward fastest, it is fair to say that greediness can accomplish goodness. However, that does not mean the benefits of efficiency are not outweighed by repercussions in other areas. 'Good' is a moral term, so really it doesn't apply here anyway, but I suppose that's just semantics.

  9. Hanon 18 Dec 2010 at 1:54 pm

    this entire blog's been copied down

    as a graded assignment in my AP Econ class hahaha.

  10. faxcore.zendesk.comon 26 May 2014 at 10:16 pm

    faxcore.zendesk.com

    Why Greed is Good (or how in pursuit of their own self-interest firms do what?s best for society) | Economics in Plain English