Is the Competitive Market Efficient?

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© 2010 Pearson Addison-Wesley
REVISITING THE MARKET EQUILIBRIUM
Do the equilibrium price and quantity maximize the total
welfare of buyers and sellers?
Market equilibrium reflects the way markets allocate
scarce resources.
Whether the market allocation is desirable can be
addressed by welfare economics.
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Welfare Economics
Welfare economics is the study of how the allocation
of resources affects economic well-being.
Buyers and sellers receive benefits from taking part in
the market.
The equilibrium in a market maximizes the total welfare
of buyers and sellers.
Equilibrium in the market results in maximum benefits,
and therefore maximum total welfare for both the
consumers and the producers of the product.
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Welfare Economics
Consumer surplus measures economic welfare from the
buyer’s side.
Producer surplus measures economic welfare from the
seller’s side.
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Resource Allocation Methods
Scare resources might be allocated by









Market price
Command
Majority rule
Contest
First-come, first-served
Sharing equally
Lottery
Personal characteristics
Force
How does each method work?
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Resource Allocation Methods
Market Price
When a market allocates a scarce resource, the people
who get the resource are those who are willing to pay
the market price.
Most of the scarce resources that you supply get
allocated by market price.
You sell your labor services in a market, and you buy
most of what you consume in markets.
For most goods and services, the market turns out to do
a good job.
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Resource Allocation Methods
Command
Command system allocates resources by the order
(command) of someone in authority.
For example, if you have a job, most likely someone
tells you what to do. Your labor time is allocated to
specific tasks by command.
A command system works well in organizations with
clear lines of authority but badly in an entire economy.
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Resource Allocation Methods
Majority Rule
Majority rule allocates resources in the way the majority
of voters choose.
Societies use majority rule for some of their biggest
decisions.
For example, tax rates that allocate resources between
private and public use and tax dollars between
competing uses such as defense and health care.
Majority rule works well when the decision affects lots of
people and self-interest must be suppressed to use
resources efficiently.
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Resource Allocation Methods
Contest
A contest allocates resources to a winner (or group of
winners).
The most obvious contests are sporting events but they
occur in other arenas:
For example, The Oscars are a type of contest.
Contest works well when the efforts of the “players” are
hard to monitor and reward directly.
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Resource Allocation Methods
First-Come, First-Served
A first-come, first-served allocates resources to those
who are first in line.
Casual restaurants use first-come, first served to
allocate tables. Supermarkets also uses first-come, firstserved at checkout.
First-come, first-served works best when scarce
resources can serves just one person at a time in a
sequence.
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Resource Allocation Methods
Sharing Equally
When a resource is shared equally, everyone gets the
same amount of it.
You might use this method to share a dessert in a
restaurant.
To make sharing equally work, people must be in
agreement about its use and implementation.
It works best for small groups who share common goals
and ideals.
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Resource Allocation Methods
Lottery
Lotteries allocate resources to those with the winning
number, draw the lucky cards, or come up lucky on
some other gaming system.
State lotteries and casinos reallocate millions of dollars
worth of goods and services each year.
But lotteries are more widespread. For example, they
are used to allocate landing slots at some airports.
Lotteries work well when there is no effective way to
distinguish among potential users of a scarce resource.
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Resource Allocation Methods
Personal Characteristics
Personal characteristics allocate resources to those
with the “right” characteristics.
For example, people choose marriage partners on the
basis of personal characteristics.
But this method gets used in unacceptable ways:
allocating the best jobs to white males and
discriminating against minorities and women.
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Resource Allocation Methods
Force
Force plays a role in allocating resources.
For example, war has played an enormous role
historically in allocating resources.
Theft, taking property of others without their consent,
also plays a large role.
But force provides an effective way of allocating
resources—for the state to transfer wealth from the rich
to the poor and establish the legal framework in which
voluntary exchange can take place in markets.
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Demand and Marginal benefit
Demand and Willingness to Pay
Willingness to pay is the maximum amount that a buyer
will pay for a good.
It measures how much the buyer values the good or
service.
The market demand curve depicts the various quantities
that buyers would be willing and able to purchase at
different prices.
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Demand and Marginal benefit
Individual Demand and Market Demand
The relationship between the price of a good and the
quantity demanded by one person is called individual
demand.
The relationship between the price of a good and the
quantity demanded by all buyers in the market is called
market demand.
Figure 5.1 on the next slide shows the connection between
individual demand and market demand.
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Demand and Marginal benefit
Lisa and Nick are the only buyers in the market for pizza.
At $1 a slice, the quantity demanded by Lisa is 30 slices.
At $1 a slice, the quantity demanded by Nick is 10 slices.
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Demand and Marginal benefit
At $1 a slice, the quantity demanded by Lisa is 30 slices
and by Nick is 10 slices.
The quantity demanded by all buyers in the market is 40 slices.
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Consumer Surplus
The market demand curve is the horizontal sum of the
individual demand curves.
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Consumer Surplus
Consumer surplus is the buyer’s willingness to pay for a
good minus the amount the buyer actually pays for it.
It is measured by the area under the demand curve and
above the price paid, up to the quantity bought.
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Example: Four Possible Buyers’ Willingness to Pay
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Copyright©2004 South-Western
The Demand Schedule and the
Demand Curve
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The Demand Schedule and the Demand Curve
Price of
Album
John’s willingness to pay
$100
Paul’s willingness to pay
80
George’s willingness to pay
70
Ringo’s willingness to pay
50
Demand
0
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1
2
3
4
Quantity of
Albums
Copyright©2003 Southwestern/Thomson Learning
Measuring Consumer Surplus with the Demand Curve
(a) Price = $80
Price of
Album
$100
John’s consumer surplus ($20)
80
70
50
Demand
0
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1
2
3
4
Quantity of
Albums
Copyright©2003 Southwestern/Thomson Learning
Measuring Consumer Surplus with the Demand Curve
(b) Price = $70
Price of
Album
$100
John’s consumer surplus ($30)
80
Paul’s consumer
surplus ($10)
70
50
Total
consumer
surplus ($40)
Demand
0
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1
2
3
4 Quantity of
Albums
Copyright©2003 Southwestern/Thomson Learning
How the Price Affects Consumer Surplus
(a) Consumer Surplus at Price P
Price
A
Consumer
surplus
P1
B
C
Demand
0
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Q1
Quantity
Copyright©2003 Southwestern/Thomson Learning
How the Price Affects Consumer Surplus
(b) Consumer Surplus at Price P
Price
A
Initial
consumer
surplus
P1
P2
0
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C
B
Consumer surplus
to new consumers
F
D
E
Additional consumer
surplus to initial
consumers
Q1
Demand
Q2
Quantity
Copyright©2003 Southwestern/Thomson Learning
Consumer Surplus
What Does Consumer Surplus Measure?
Consumer surplus, the amount that buyers are willing to
pay for a good minus the amount they actually pay for it,
measures the benefit that buyers receive from a good as
the buyers themselves perceive it.
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Supply and Marginal Cost
Supply, Cost, and Minimum Supply-Price
Cost is what the producer gives up, price is what the
producer receives.
The cost of one more unit of a good or service is its
marginal cost.
Marginal cost is the minimum price that a firm is willing to
accept.
But the minimum supply-price determines supply.
A supply curve is a marginal cost curve.
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Supply and Marginal Cost
Individual Supply and Market Supply
The relationship between the price of a good and the
quantity supplied by one producer is called individual
supply.
The relationship between the price of a good and the
quantity supplied by all producers in the market is called
market supply.
Figure 5.3 on the next slide shows the connection between
individual supply and market supply.
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Supply and Marginal Cost
Max and Mario are the only producers of pizza.
At $15 a pizza, the quantity supplied by Max is 100 pizzas.
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Supply and Marginal Cost
Max and Mario are the only producers of pizza.
At $15 a pizza, the quantity supplied by Mario is 50 pizzas.
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Supply and Marginal Cost
At $15 a pizza, the quantity supplied by Max is 100 pizzas
and by Mario is 50 pizzas.
The quantity supplied by all producers is 150 pizzas.
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Supply and Marginal Cost
The market supply curve is the horizontal sum of the
individual supply curves.
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Supply and Marginal Cost
Producer Surplus
Producer surplus is the price received for a good minus
the minimum-supply price (marginal cost), summed over
the quantity sold.
It is measured by the area below the market price and
above the supply curve, summed over the quantity sold.
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The Costs of Four Possible Sellers
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Copyright©2004 South-Western
Using the Supply Curve to Measure
Producer Surplus
Just as consumer surplus is related to the demand curve,
producer surplus is closely related to the supply curve.
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The Supply Schedule and the Supply
Curve
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The Supply Schedule and the Supply Curve
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Using the Supply Curve to Measure
Producer Surplus
The area below the price and above the supply curve
measures the producer surplus in a market.
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Measuring Producer Surplus with the Supply Curve
(a) Price = $600
Price of
House
Painting
Supply
$900
800
600
500
Grandma’s producer
surplus ($100)
0
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1
2
3
4
Quantity of
Houses Painted
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Measuring Producer Surplus with the Supply Curve
(b) Price = $800
Price of
House
Painting
$900
Supply
Total
producer
surplus ($500)
800
600
Georgia’s producer
surplus ($200)
500
Grandma’s producer
surplus ($300)
0
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1
2
3
4
Quantity of
Houses Painted
Copyright©2003 Southwestern/Thomson Learning
How the Price Affects Producer Surplus
(a) Producer Surplus at Price P
Price
Supply
P1
B
Producer
surplus
C
A
0
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Q1
Quantity
Copyright©2003 Southwestern/Thomson Learning
How the Price Affects Producer Surplus
(b) Producer Surplus at Price P
Price
Supply
Additional producer
surplus to initial
producers
P2
P1
D
E
F
B
Initial
producer
surplus
C
Producer surplus
to new producers
A
0
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Q1
Q2
Quantity
Copyright©2003 Southwestern/Thomson Learning
MARKET EFFICIENCY
Consumer surplus and producer surplus may be used
to address the following question:
Is the allocation of resources determined by free
markets in any way desirable?
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MARKET EFFICIENCY
Consumer Surplus
= Value to buyers – Amount paid by buyers
Producer Surplus
= Amount received by sellers – Cost to sellers
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MARKET EFFICIENCY
Total surplus
= Consumer surplus + Producer surplus
or
Total surplus
= Value to buyers – Cost to sellers
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MARKET EFFICIENCY
Efficiency is the property of a resource allocation of
maximizing the total surplus received by all
members of society.
In addition to market efficiency, a social planner might
also care about equity – the fairness of the
distribution of well-being among the various buyers
and sellers.
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Is the Competitive Market Efficient?
Efficiency of Competitive
Equilibrium
Figure 5.5 shows that a
competitive market creates
an efficient allocation of
resources at equilibrium.
In equilibrium, the quantity
demanded equals the
quantity supplied.
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Is the Competitive Market Efficient?
At the equilibrium quantity,
marginal benefit equals
marginal cost, so the
quantity is the efficient
quantity.
When the efficient quantity
is produced, total surplus
(the sum of consumer
surplus and producer
surplus) is maximized.
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MARKET EFFICIENCY
Three Insights Concerning Market Outcomes
Free markets allocate the supply of goods to the
buyers who value them most highly, as measured by
their willingness to pay.
Free markets allocate the demand for goods to the
sellers who can produce them at least cost.
Free markets produce the quantity of goods that
maximizes the sum of consumer and producer surplus.
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The Efficiency of the Equilibrium Quantity
Price
Supply
Value
to
buyers
Cost
to
sellers
Cost
to
sellers
0
Value
to
buyers
Equilibrium
quantity
Value to buyers is greater
than cost to sellers.
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Demand
Quantity
Value to buyers is less
than cost to sellers.
Copyright©2003 Southwestern/Thomson Learning
Evaluating the Market Equilibrium
Because the equilibrium outcome is an efficient
allocation of resources, the social planner can leave
the market outcome as he/she finds it.
This policy of leaving well enough alone goes by the
French expression laissez faire.
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Is the Competitive Market Efficient?
The Invisible Hand
Adam Smith’s “invisible hand” idea in the Wealth of
Nations implied that competitive markets send resources
to their highest valued use in society.
Consumers and producers pursue their own self-interest
and interact in markets.
Market transactions generate an efficient—highest
valued—use of resources.
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Is the Competitive Market Efficient?
Underproduction and Overproduction
Inefficiency can occur because too little of an item is
produced—underproduction—or too much of an item is
produced—overproduction.
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Is the Competitive Market Efficient?
Underproduction
The efficient quantity is
10,000 pizzas a day.
If production is restricted to
5,000 pizzas a day, there
is underproduction and the
quantity is inefficient.
A deadweight loss equals
the decrease in total
surplus—the gray triangle.
This loss is a social loss.
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Is the Competitive Market Efficient?
Overproduction
Again, the efficient quantity
is 10,000 pizzas a day.
If production is expanded
to 15,000 pizzas a day, a
deadweight loss arises
from overproduction.
This loss is a social loss.
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Is the Competitive Market Efficient?
Obstacles to Efficiency
In competitive markets, underproduction or
overproduction arise when there are
 Price
and quantity regulations
 Taxes
and subsidies
 Externalities
 Public
goods and common resources
 Monopoly
 High
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transactions costs
Is the Competitive Market Efficient?
Price and Quantity Regulations
Price regulations sometimes put a block of the price
adjustments and lead to underproduction.
Quantity regulations that limit the amount that a farm is
permitted to produce also leads to underproduction.
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Is the Competitive Market Efficient?
Taxes and Subsidies
Taxes increase the prices paid by buyers and lower the
prices received by sellers.
So taxes decrease the quantity produced and lead to
underproduction.
Subsidies lower the prices paid by buyers and increase
the prices received by sellers.
So subsidies increase the quantity produced and lead to
overproduction.
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Is the Competitive Market Efficient?
Externalities
An externality is a cost or benefit that affects someone
other than the seller or the buyer of a good.
An electric utility creates an external cost by burning
coal that creates acid rain.
The utility doesn’t consider this cost when it chooses the
quantity of power to produce. Overproduction results.
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Is the Competitive Market Efficient?
Public Goods and Common Resources
A public good benefits everyone and no one can be
excluded from its benefits.
It is in everyone’s self-interest to avoid paying for a
public good (called the free-rider problem), which leads
to underproduction.
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Is the Competitive Market Efficient?
A common resource is owned by no one but can be
used by everyone.
It is in everyone’s self interest to ignore the costs of
their own use of a common resource that fall on others
(called tragedy of the commons).
The tragedy of the commons leads to overproduction.
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Is the Competitive Market Efficient?
Monopoly
A monopoly is a firm that has sole provider of a good or
service.
The self-interest of a monopoly is to maximize its profit.
To do so, a monopoly sets a price to achieve its selfinterested goal.
As a result, a monopoly produces too little and
underproduction results.
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Is the Competitive Market Efficient?
High Transactions Costs
Transactions costs are the opportunity cost of making
trades in a market.
To use the market price as the allocator of scarce
resources, it must be worth bearing the opportunity cost
of establishing a market.
Some markets are just too costly to operate.
When transactions costs are high, the market might
underproduce.
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Is the Competitive Market Efficient?
Alternatives to the Market
When a market is inefficient, can one of the non-market
methods of allocation do a better job?
Often, majority rule might be used.
But majority rule has its own shortcomings. A group
that pursues the self-interest of its members can
become the majority.
Also, with majority rule, votes must be translated into
actions by bureaucrats who have their own agendas.
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Is the Competitive Market Efficient?
There is no one efficient mechanism for allocating
resources efficiently.
But supplemented majority rule, bypassed inside firms
by command systems, and occasionally using firstcome, first-served, markets do an amazingly good job.
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Is the Competitive Market Fair?
Ideas about fairness can be divided into two groups:

It’s not fair if the result isn’t fair.

It’s not fair if the rules aren’t fair.
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Is the Competitive Market Fair?
It’s Not Fair if the Result Isn’t Fair
The idea that only equality brings efficiency is called
utilitarianism.
Utilitarianism is the principle that states that we should
strive to achieve “the greatest happiness for the greatest
number.”
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Is the Competitive Market Fair?
If everyone gets the same marginal utility from a given
amount of income, and
if the marginal benefit of income decreases as income
increases,
then taking a dollar from a richer person and giving it to a
poorer person increases the total benefit.
Only when income is equally distributed has the greatest
happiness been achieved.
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Is the Competitive Market Fair?
Figure 5.7 shows how
redistribution increases
efficiency.
Tom is poor and has a
high marginal benefit of
income.
Jerry is rich and has a low
marginal benefit of income.
Taking dollars from Jerry
and giving them to Tom until
they have equal incomes
increases total benefit.
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Is the Competitive Market Fair?
Utilitarianism ignores the cost of making income transfers.
Recognizing these costs leads to the big tradeoff
between efficiency and fairness.
Because of the big tradeoff, John Rawls proposed that
income should be redistributed to point at which the
poorest person is as well off as possible.
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Is the Competitive Market Fair?
It’s Not Fair If the Rules Aren’t Fair
The idea that “it’s not fair if the rules aren’t fair” is based
on the symmetry principle.
Symmetry principle is the requirement that people in
similar situations be treated similarly.
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Is the Competitive Market Fair?
In economics, this principle means equality of opportunity,
not equality of income.
Robert Nozick suggested that fairness is based on two
rules:

The state must create and enforce laws that establish
and protect private property.

Private property may be transferred from one person to
another only by voluntary exchange.
This means that if resources are allocated efficiently, they
may also be allocated fairly.
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Summary
Consumer surplus equals buyers’ willingness to pay
for a good minus the amount they actually pay for it.
Consumer surplus measures the benefit buyers get
from participating in a market.
Consumer surplus can be computed by finding the
area below the demand curve and above the price.
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Summary
Producer surplus equals the amount sellers receive for
their goods minus their costs of production.
Producer surplus measures the benefit sellers get from
participating in a market.
Producer surplus can be computed by finding the area
below the price and above the supply curve.
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Summary
An allocation of resources that maximizes the sum of
consumer and producer surplus is said to be
efficient.
Policymakers are often concerned with the efficiency,
as well as the equity, of economic outcomes.
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Summary
The equilibrium of demand and supply maximizes the
sum of consumer and producer surplus.
This is as if the invisible hand of the marketplace leads
buyers and sellers to allocate resources efficiently.
Markets do not allocate resources efficiently in the
presence of market failures.
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