Why should markets (in general) be allocatively efficient? List any assumptions you make.
Allocative efficiency refers to economic efficiency where the economy or the producers in an
economy produces goods with high demand and which are more marketable and desirable in a
given society. The point of the allocative efficiency is that point where the Marginal Benefit
equals to the Marginal Cost. It equals to the level of output that is produced less the value of the
total resources that has been used. The total surplus without any dead weight is maximized. The
assumptions under these concept of allocative is that the market should not have concentrated
market power i.e. monopolies or oligopolies or existence of imperfect knowledge in the market
nor differentiated goods. Allocative efficiency is applicable in a free market that operates under
perfect competition which is mostly efficient. Markets should be allocatively efficient in order to
utilize all the resources efficiently and guarantees that all the wants, tastes and the needs of all
people are adequately met using the available resources. ( Pilbeam, 2005)
Given your answer to part 1, what does it mean for financial markets to be efficient and
why should financial markets be allocatively efficient?
Financial markets are efficient when the available resources are optimally utilized to the full
benefit of the financiers of the market i.e. it refers to the efficiency of allocating resources.
Allocative efficiency in financial markets refers to a condition where no one willing trader is
willing to trade his goods in a way as to increase or add benefits to the mutual parties i.e. it
brings to light the theory of Pareto-optimal state. It’s a situation where no one can gain without
someone else losing or becoming worse off hence not a really optimal situation. It basically
directs funds from the lenders to the borrowers in the best way possible socially. Financial
market efficiencies are in three basic levels. The weak-form efficiency involves the prices of
securities reflecting the past and immediate price of their values. It means that the future prices
cannot be predicted by analyzing the past prices. (Barr, 2012) The prices are randomly arrived at.
In semi-strong efficiency the asset prices reflect all the required information to the public.
Investors also would have comparative advantage in the market as accessing the market inside
information would be to their advantage. Price anomalies are quickly noted and adjustments
made. Strong –form efficiency reflects the inside as well as the public information that’s
available. This way no one has an upper hand in market information. Prediction of prices is non-
existent as no data is available to other investors.
When could financial systems fail to allocate resources to their most desirable use?
Financial systems fail when the freely-functioning financial markets inadequately allocate
resources and fail to ensure the efficient utilization of the resources. The financial systems fail
because of negative externalities for instance when the production social costs surpass the private
costs. Also the positive externalities that results in private benefits been exceeded by the benefits
from the additional benefits. Situations where the information is imperfect may lead to
underproduction of the merit goods while the demerit goods are over produced. A situation that
leads to financial systems failure to adequately allocate its scarce resources. A market that has
been dominated by monopolies may lead to under production and over pricing that eventually
leads to the collapse of the financial systems. Allocative inefficiency may result in financial
systems failing in allocating resources as they are directed to the production of unwanted goods
and services that are not needed by the consumers. The system can also fail when laws are
enacted that outlaw production of certain products or restricts certain practices that originally
promoted certain profitable products that are adversely affected by the new statutes.
The January effect can also affect the financial system and compromise its efficiency. Stock
market crashes and investors who outperform the markets.
Barr, N. (2012) The relevance of efficiency to different theories of society . Economics of the
Welfare State (5th Ed.). Oxford University Press. p. 46
Pilbeam, K. (2005). Finance and Financial Markets. Palgrave Macmillan. ISBN 978-1-4039-