Chapter 16
Competition and efficiency
To begin with …
16.1 Efficiency in economics
16.2 Perfect competition and efficiency
16.3 Inefficiency and deadweight loss
16.4 Deviations from efficiency
1
Chapter 16
To begin with …
We have used the concept of total social surplus
(TSS) to measure the total gains from market
exchange.
$
S
TSS
0
D
Q0
Q
2
Chapter 16
To begin with …
In this chapter, we will
1. discuss the conditions for efficiency with the
concept of TSS;
2. explain how a perfectly competitive market can
allocate resources efficiently; and
3. discuss the effects of government intervention
on efficiency.
3
Chapter 16
Task 16.1
We hear the word ‘efficiency’ all the time.
Dictionary:
Efficiency means ‘the quality of doing something well
and effectively, without wasting time, money, or energy’.
Do you know the meaning of ‘efficiency’ in economics?
Answer:
In economics, efficiency in resource allocation is attained
when the total social surplus is maximised.
4
Chapter 16
16.1 Efficiency in economics
5
Chapter 16
A. Definition of efficiency
Efficiency in resource allocation is attained
when the total social surplus (TSS) is maximised.
6
Chapter 16
B. The conditions for efficiency in
resource allocation
1. MB = MC
2. Maximisation of the sum of CS and PS
(when there are only consumers and producers
in the market.)
3. MSB = MSC (when there is externality)
[discussed in Chapter 17]
7
Chapter 16
16.2 Perfect competition and
efficiency
8
Chapter 16
16.2 Perfect competition and efficiency
In a perfectly competitive market,
 all consumers consume up to a point where MB = P
in order to maximise CS;
 all producers produce up to a point where MC = P in
order to maximise PS.
As a result,
$
 MB = MC;
 the total gain from market
exchange is maximised;
S = MC
CS
Pe
PS
 the market has achieved
efficiency.
0
Qe
D = MB
Q
9
Chapter 16
16.3 Inefficiency and
deadweight loss
10
Chapter 16
16.3 Inefficiency and deadweight loss
 Inefficiency in resource allocation implies that the TSS
is not maximised.
 This occurs when MB
MC.
 As the market fails to allocate resource efficiently,
there must be a deadweight loss.
Deadweight loss can be :
 potential gains not being captured when MB > MC
(i.e., underproduction)
 the loss in total social surplus when MB < MC
(i.e., overproduction)
11
Chapter 16
1. Underproduction
When the output level is below the efficient level,
there is underproduction.
Suppose the output level is Q1,
which is below the efficient
level Qe.
For units from Q1 to Qe (except
for Qe), MB > MC.
A deadweight loss (Area abc)
exists as some potential gains
are not fully captured.
Deadweight loss
$
MB1
S = MC
a
b
Pe
MC1
c
0
Q1
Qe
D = MB
Q
12
Chapter 16
1. Underproduction
When the output level is below the efficient level,
there is underproduction.
It is possible to increase TSS
by expanding production.
The output level Q1 is not
efficient.
Deadweight loss
$
MB1
S = MC
a
b
Pe
MC1
c
0
Q1
Qe
D = MB
Q
13
Chapter 16
2. Overproduction
When the output level is above the efficient level,
there is overproduction.
Suppose the output level is Q2,
which is above the efficient
level Qe.
For units from Qe to Q2 (except
for Qe), MB < MC.
A deadweight loss (Area xyz)
exists as there is a loss in
TSS.
Deadweight loss
$
y
MC2
Pe
x
MB2
0
S = MC
z
Qe
Q2
D = MB
Q
14
Chapter 16
2. Overproduction
When the output level is above the efficient level,
there is overproduction.
It is possible to increase TSS
by cutting production.
The output level Q2 is not
efficient.
Deadweight loss
$
y
MB2
Pe
x
MC2
0
S = MC
z
Qe
Q2
D = MB
Q
15
Chapter 16
Test yourself 16.1
Refer to the table on the right.
Calculate the value of the deadweight
loss for each of the following output
levels. Based on your result,
determine which of them is inefficient.
a. 2 units
b. 4 units
c. 5 units
Quantity
(units)
MB ($)
MC ($)
1
13
1
2
11
2
3
8
3
4
4
4
5
0
5
Answer:
a. Deadweight loss = (MB of 3rd unit – MC of 3rd unit) +
(MB of 4th unit – MC of 4th unit) = $ 5 + $0 = $ 5
 Efficient / Inefficient
16
Chapter 16
Test yourself 16.1
Refer to the table on the right.
Calculate the value of the deadweight
loss for each of the following output
levels. Based on your result,
determine which of them is inefficient.
a. 2 units
b. 4 units
c. 5 units
Quantity
(units)
MB ($)
MC ($)
1
13
1
2
11
2
3
8
3
4
4
4
5
0
5
Answer:
b. Deadweight loss = $0  Efficient / Inefficient
17
Chapter 16
Test yourself 16.1
Refer to the table on the right.
Calculate the value of the deadweight
loss for each of the following output
levels. Based on your result,
determine which of them is inefficient.
a. 2 units
b. 4 units
c. 5 units
Quantity
(units)
MB ($)
MC ($)
1
13
1
2
11
2
3
8
3
4
4
4
5
0
5
Answer:
c. Deadweight loss = MC of 5th unit – MB of 5th unit = $5
 Efficient / Inefficient)
18
Chapter 16
Go further 16.1
Efficiency and the invisible hand
Government intervention in the
market is commonly known as
the ‘ visible hand’. The ‘invisible
hand’ also exists. What is an
invisible hand?
 Under the market mechanism,
no individual plays a role in
coordinating all production and
consumption.
 However, all individuals pursuing
their own interest help achieve
market equilibrium and bring the
most advantages to society.
Fig. 16.4 The idea of the
invisible hand was put forward
by Adam Smith (1723–1790), the
father of modern economics.
19
Chapter 16
Go further 16.1
Efficiency and the invisible hand
 Consumers consume up to
the quantity where MB = P
and producers produce up to
the quantity where MC = P.
Efficiency is attained when
MB = P = MC.
 The market price is said to
act as an invisible hand,
guiding individual decisions
to bring the maximum gain to
the economy as a whole.
Fig. 16.4 The idea of the
invisible hand was put forward
by Adam Smith (1723–1790), the
father of modern economics.
20
Chapter 16
Go further 16.1
Efficiency and the invisible hand
 Hong Kong is the closest example that can be used to
illustrate how the invisible hand allocates resources.
... Hong Kong followed a laissez-faire capitalist policy ... The results of
(t)his policy were remarkable. At the end of World War II, Hong Kong
was a dirt-poor island with a per capita income about one-quarter that
of Britain’s. By 1997, ... its per capita income was roughly equal to that
of the departing colonial power, even though Britain had experienced
sizable growth over the same period. That was a striking demonstration
of the productivity of freedom, of what people can do when they are
left free to pursue their own interests ...
Milton Friedman
6 October 2006
21
Chapter 16
16.4 Deviations from
efficiency
22
Chapter 16
16.4 Deviations from efficiency
The government may sometimes intervene in a market.
This may lead to inefficiency.
Common types of government intervention
Price control
Price ceiling
Quantity control
Price floor
Unit tax
Unit subsidy
Quota
23
Chapter 16
Task 16.2
Who is right? Why?
After the imposition of an
effective price ceiling, the
market price will decrease.
Consumers must gain.
Carrie
No. Consumers
may not gain
because...
Peter
Answer:
Carrie / Peter is right. Even though the market price
decreases, consumers as a whole may not gain because
the quantity transacted increases / decreases after the
imposition of an effective price ceiling.
24
Chapter 16
Task 16.2
Who is right? Why?
After the imposition of an
effective price ceiling, the
market price will decrease.
Consumers must gain.
Carrie
No. Consumers
may not gain
because...
Peter
Answer:
Consumer surplus (CS) may decrease. The change in
consumer surplus depends on the size of the gain / loss
in CS (due to price decrease) relative to the gain / loss in
CS (due to quantity decrease).
25
Chapter 16
A. Price ceiling
After the imposition of an effective price ceiling:
 Quantity transacted will
decrease from Qe to QC.
A
 At QC, MB > MC.
PX
 Some potential gains are
not fully captured.
 A deadweight loss
is incurred from
underproduction.
$
Pe
PC
S = MC
C
G
E
Price
ceiling
D = MB
F
B
0
QC
Qe
Q
 The market is not efficient.
26
Chapter 16
A. Price ceiling
After the imposition of an effective price ceiling:
 The producer surplus (PS)
decreases from Area
PeGB to Area PcFB.
 The consumer surplus (CS)
changes from Area PeGA to
Area ACFPc. It may
increase, decrease, or
remain unchanged,
depending on the size of
the gain in CS relative to
the loss in CS.
$
A
S = MC
C
PX
Pe
PC
G
E
Price
ceiling
D = MB
F
B
0
QC
Qe
Q
27
Chapter 16
A. Price ceiling
$
$
S = MC
Pe
PC
S = MC
C
EY G
X
F
C
Pe
Price
ceiling
PC
E Y
X
F
G
Price
ceiling
D = MB
0
QC Qe
Q
a. CS increases as
Gain in CS (X) > Loss in CS (Y).
Fig. 16.6
D = MB
0
QC
Qe
Q
b. CS decreases as
Gain in CS (X) < Loss in CS (Y).
Change in CS depends on the relative size of the gain in CS and loss in CS.
28
Chapter 16
Task 16.3
Peter is right. Can you explain why?
I think the minimum
wage law can benefit
workers as their
income increases.
Carrie
Not all workers can
benefit from the minimum
wage. Workers as a
whole may be worse off
than before.
Peter
Answer:
As discussed in Chapter 6 of book 1, some workers will
become unemployed. In terms of producer surplus (PS),
workers as a whole may be worse off if the gain / loss in PS
(due to wage increase) is greater / smaller than the gain /
loss in PS (due to quantity decrease).
29
Chapter 16
B. Price floor
After the imposition of an effective price floor:
 Quantity transacted will
decrease from Qe to Qf.
A
 At Qf, MB > MC.
Pf
 Some potential gains are
not fully captured.
Pe
 A deadweight loss
is incurred from
underproduction.
$
PX
S = MC
C
G
E
F
D = MB
B
0
Price
floor
Qf
Qe
Q
 The market is not efficient.
30
Chapter 16
B. Price floor
After the imposition of an effective price floor:
 The CS decreases from
Area AGPe to Area ACPf.
 The PS changes from Area
BGPe to Area BFCPf. It may
increase, decrease or remain
unchanged, depending on
the size of the gain in PS
relative to the loss in PS.
$
A
S = MC
C
Pf
Pe
PX
G
E
F
D = MB
B
0
Price
floor
Qf
Qe
Q
31
Chapter 16
B. Price floor
$
$
S = MC
S = MC
Pf
Pe
C
G
X
Price
floor
E Y
F
Pf
Pe
Qf
Qe
Q
a. PS increases as
Gain in PS (X) > Loss in PS (Y).
Fig. 16.8
Price
floor
G
X
E
Y
D = MB
F
D = MB
0
C
0
Qf
Qe
Q
b. PS decreases as
Gain in PS (X) < Loss in PS (Y).
Change in PS depends on the relative size of the gain in PS and loss in PS.
32
Chapter 16
Learning tips 16.1
c
Excess demand, excess supply and underproduction
In both cases of excess demand and excess supply,
there are underproduction.
The quantities transacted are lower than the efficient
output level. As a result, MB > MC.
Therefore, to determine whether there is
underproduction or overproduction, we should:
 compare MB with MC at the quantity transacted, OR
 compare the quantity transacted with the efficient
output level.
33
Chapter 16
Test yourself 16.2
Summarise the effects of an effective price ceiling and an effective
price floor in a perfectly competitive market by choosing the correct
answers in the table below.
Effective
price ceiling
Effective
price floor
Is MB greater than, equal
to or smaller than MC at
quantity transacted?
MB > / = / < MC
MB > / = / < MC
Change in TSS
 /  / uncertain
 /  / uncertain
Yes / No
(underproduction /
overproduction)
Yes / No
(underproduction /
overproduction)
Change in Q
 /  / uncertain
 /  / uncertain
Change in P
 /  / uncertain
 /  / uncertain
Change in CS
 /  / uncertain
 /  / uncertain
Change in PS
 /  / uncertain
 /  / uncertain
Achieve efficiency in
resource allocation?
34
Chapter 16
Test yourself 16.3
Suppose the government has imposed an effective price
ceiling on rental housing. Without using a diagram, what
can you tell about the change in TSS and the state of
market efficiency under each of the following situations?
a. The price ceiling becomes ineffective due to a
decrease in demand for rental housing.
Answer:
TSS will increase / decrease but market efficiency
is / is not achieved.
35
Chapter 16
Test yourself 16.3
Suppose the government has imposed an effective price
ceiling on rental housing. Without using a diagram, what
can you tell about the change in TSS and the state of
market efficiency under each of the following situations?
b. The government removes the price ceiling.
Answer:
TSS will increase / decrease and market efficiency
is / is not achieved.
36
Chapter 16
Test yourself 16.4
Applying what you have learned in this chapter, explain
why an effective minimum wage may NOT benefit the
workers.
Answer:
In terms of producer surplus (PS), workers as a whole
may be worse off under an effective minimum wage if
the gain / loss in PS (due to wage increase) is greater /
smaller than the gain / loss in PS (due to quantity
decrease). [see Fig. 16.8 (b)]
37
Chapter 16
Past exam Q
1. The following diagram shows the demand and supply curves of
good X in a perfectly competitive market.
Suppose a price floor is set at P1.
As a result,
A. the deadweight loss is equal
to area BEF.
B. the producer surplus is equal
to area P1BC0.
C. the consumer surplus is equal
to area AEPe.
D. the total social surplus is equal
to area P1BCG.
Price ($)
A
P1
Pe
G
S
B
E
F
C
0
D
Quantity
(HKDSE Practice Paper, Q15)
38
Chapter 16
C. Quota
After the imposition of an effective quota:
 Quantity transacted will
decrease from Qe to Qq.
A
 At Qq, MB > MC.
Pq
 Some potential gains are
not fully captured.
Pe
 A deadweight loss
is incurred from
underproduction.
$
PX
S’’
S = MC
E
G
F
S’
D = MB
C
0
Qq
Qe
Q
 The market is not efficient.
39
Chapter 16
C. Quota
After the imposition of an effective quota:
 The CS decreases from
Area AGPe to AEPq.
 The PS changes from Area
PeGC to Area PqES’C. It
may increase, decrease, or
remain unchanged,
depending on the size of
the gain in PS relative to
the loss in PS.
$
S’’
A
E
Pq
Pe
PX
S = MC
G
F
S’
D = MB
C
0
Qq
Qe
Q
40
Chapter 16
Test yourself 16.5
Summarise the effects of an effective quota in a perfectly competitive
market by choosing the correct answers in the table below.
Is MB greater than, equal
to or smaller than MC at
quantity transacted?
MB > / = / < MC
Change in TSS
 /  / uncertain
Achieve efficiency in
resource allocation?
Yes / No
(underproduction /
overproduction)
Change in Q
 /  / uncertain
Change in P
 /  / uncertain
Change in CS
 /  / uncertain
Change in PS
 /  / uncertain
41
Chapter 16
Past exam Q
2. Refer to the following demand-supply diagram of a good with the
government setting a quota at Q1.
Which of the following will be the result
of a reduction in quota on the good?
(1) The total expenditure on the good
may increase or decrease.
(2) The consumer surplus will
decrease.
(3) The total social surplus may
increase or decrease.
A.
B.
C.
D.
(1) only
(1) and (2) only
(2) and (3) only
(1), (2) and (3)
Price
S1
S0
D0
0
Quantity
(HKDSE 2013, Q19)
42
Chapter 16
D. Unit taxes
After the imposition of a unit tax:
 Quantity transacted will
decrease from Qe to Qt.
 At Qt, MB > MC. (MC is
measured by S1, the
original supply curve
without subsidy.)
 Some potential gains are
not fully captured.
$
S2 = MC + Unit tax
Tax S1 = MC
A
P1
Pe
P2
C
G
E
F
B
0
 A deadweight loss
is incurred from underproduction.
D = MB
Qt
Qe
Q
 The market is not efficient.
43
Chapter 16
D. Unit taxes
After the imposition of a unit tax:
 The CS decreases by
Area P1CGPe, and
becomes Area ACP1.
 The PS decreases by
Area PeGFP2, and
becomes Area P2FB.
 The government’s tax
revenue is equal to Area
P1CFP2.
$
S2 = MC + Unit tax
Tax S1 = MC
A
P1
Pe
P2
C
G
E
F
B
0
D = MB
Qt
Qe
Q
Total social surplus = Consumer + Producer + Tax
under unit tax
surplus
surplus
revenue
44
Chapter 16
D. Unit taxes
P1
P2
P1
C
Tax
collected
<
Pe
F
P2
C
CS
PS
G
Deadweight loss
F
$
S2 = MC + Unit tax
Tax S1 = MC
A
P1
Pe
P2
C
G
E
F
B
0
D = MB
Qt
Qe
Q
45
Chapter 16
Test yourself 16.6
Suppose the government increases a unit tax on a good.
Explain how this would affect the following:
a. Consumer surplus
Answer:
Increase / Decrease. This is because the market price
increases / decreases and the quantity consumed
increases / decreases.
46
Chapter 16
Test yourself 16.6
Suppose the government increases a unit tax on a good.
Explain how this would affect the following:
b. Producer surplus
Answer:
Increase / Decrease. This is because both the price
received and the quantity sold increase / decrease.
c. Government’s tax revenue
Answer:
Uncertain. The change in tax revenue depends on
the elasticities of demand and supply.
47
Chapter 16
Test yourself 16.6
Suppose the government increases a unit tax on a good.
Explain how this would affect the following:
d. Total social surplus
Answer:
Increase / Decrease. Even if the tax revenue increases,
the extra tax revenue collected is still greater / smaller
than the increase / decrease in the sum of the consumer
surplus and the producer surplus.
48
Chapter 16
Task 16.4
I think a subsidy is different
from other government
measures such as unit tax,
price ceiling and price floor.
Both consumers and producers
enjoy the benefit of a subsidy.
Thus, no one suffers from it.
The total surplus must increase.
Why?
Carrie
Peter
Oh! I guess you have
missed something.
Do you agree with Carrie? Has Carrie missed anything?
Answer:
No, Carrie is wrong.
49
Chapter 16
Task 16.4
I think a subsidy is different
from other government
measures such as unit tax,
price ceiling and price floor.
Both consumers and producers
enjoy the benefit of a subsidy.
Thus, no one suffers from it.
The total surplus must increase.
Why?
Carrie
Peter
Oh! I guess you have
missed something.
Do you agree with Carrie? Has Carrie missed anything?
Answer:
Carrie has missed the point that the subsidy is paid by the government.
The total subsidy paid by the government is greater / smaller than the
increase / decrease in the sum of CS and PS. The economy as a whole
suffers as TSS increases / decreases.
50
Chapter 16
E. Unit subsidies
After the provision of a unit subsidy:
 Quantity transacted will
increase from Qe to Qu.
 At Qu, MC > MB. (Note
that MC is measured by
S1, the original supply
curve without subsidy.)
 There is a loss in the
total social surplus.
 A deadweight loss
is incurred from
overproduction.
 The market is not efficient.
$
A
P1
Pe
P2
K
B
H
}
E
Subsidy
I
G
C
0
S1 = MC
S2 = MC – Unit subsidy
D = MB
Qe Qu
Q
51
Chapter 16
E. Unit subsidies
After the provision of a unit subsidy:
 The CS increases by
Area PeEIP2, and
becomes Area AIP2.
 The PS increases by
Area P2IGK, and
becomes Area P2IC.
 The total subsidy is
Area P1HIP2.
$
A
P1
Pe
P2
K
B
H
}
E
Subsidy
I
G
C
0
S1 = MC
S2 = MC – Unit subsidy
D = MB
Qe Qu
Q
52
Chapter 16
E. Unit subsidies
Total social surplus
Consumer Producer – Total amount
=
under unit subsidy
surplus + surplus
of subsidy
A
H
=
E
–
E
I
B
Deadweight loss
Original TSS
$
S1 = MC
A
P1
Pe
P2
K
B
H
}
E
Subsidy
I
G
C
0
S2 = MC – Unit subsidy
D = MB
Qe Qu
Q
53
Chapter 16
E. Unit subsidies
Total social surplus
under unit subsidy = TB – TC
A
H
=
E
–
E
I
B
Deadweight loss
Original TSS
$
S1 = MC
A
P1
Pe
P2
K
B
H
}
E
Subsidy
I
G
C
0
S2 = MC – Unit subsidy
D = MB
Qe Qu
Q
54
Chapter 16
Learning tips 16.2
c
How to find TSS under the subsidy
 As a subsidy is a money transfer from the government
to consumers and producers, we use the original MC
curve to find the TSS.
 TSS = Sum of MSS =
Sum of the differences
between MB and MC
(i.e., Area AEB – Area
EHI)
$
S1 = MC
A
P1
Pe
P2
K
B
H
}
E
Subsidy
I
G
C
0
S2 = MC – Unit subsidy
D = MB
Qe Qu
Q
55
Chapter 16
Learning tips 16.3
c
Removal of government intervention
 Government intervention such as price controls,
quantity controls, taxes and subsidies will affect
resource allocation and lead to deadweight loss.
 If the government removes the intervention, the
deadweight loss will be avoided. This will increase
the TSS.
 Even if the government only relaxes the intervention,
the deadweight loss will become smaller and the
TSS will be greater.
56
Chapter 16
Past exam Q
3. Suppose the government provides a per-unit subsidy to the
producers of a good. This would lead to
A. an increase in consumer surplus and a fall in producer
surplus, so having an ambiguous effect on efficiency.
B. an increase in producer surplus and a fall in consumer
surplus, so having an ambiguous effect on efficiency.
C. an improvement in efficiency because both sellers and
buyers would benefit from the subsidy.
D. a deadweight loss because the amount of subsidy
provided by the government is greater than the sum of
the increase in consumer and producer surpluses.
(HKDSE Sample Paper, Q20)
57