Surplus, Efficiency, and Deadweight Loss
(“Economics” – Chapter 5)
We just finished a detailed examination of the interaction of
buyers and sellers in a market.
As a result of this
interaction, who benefits and to what degree? That is:
 How much does a buyer gain from making a purchase?
 How much does a seller gain from making a sale?
 In total, how much do buyers collectively and sellers
collectively gain from trade in a particular market?
 In total, how much does society as a whole gain from
trade in a particular market?
Recall the…
“Vertical Interpretation” of curves – start by
focusing on a particular quantity demanded (or
supplied), and then go up to the curve vertically to
determine the corresponding price at which this
particular quantity would be demanded (or supplied)
price
price
Supply
5.25
4.50
2.75
Demand
quantity
0
0
1,250
1.50
0
quantity
2,400
3,500
4,750
0
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Also recall…
Buyer’s Reservation Price – maximum dollar amount a
buyer is willing to give up in order to acquire an item
 At any particular quantity demanded, the height of the
demand curve illustrates the “reservation price” of the
buyer of that unit.
Seller’s Reservation Price – minimum dollar amount a
seller is willing to accept in order to part with an item
 At any particular quantity supplied, the height of the
supply curve illustrates the “reservation price” of the
seller of that unit.
Our measures of “benefits (or surplus) from trade” will be
based upon these reservation prices…
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Consumer’s Surplus and Producer’s Surplus:
Consumer’s Surplus: When a buyer purchases an item for
less than his reservation price he obtains a “gain” or
“surplus” from doing so.
 Example: rb  (22) and p  (15) => buyer realizes a
surplus of CS  rb  p  22  15  7 for this purchase
Producer’s Surplus: When a producer sells an item for
more than her reservation price she obtains a “gain” or
“surplus” from doing so.
 Example: rs  (12) and p  (15) => seller realizes a
surplus of PS  p  rs  15  12  3 from this sale
Social Surplus: The Social Surplus of a trade is equal to the
sum of gains over every person in society.
 For many goods, people other than buyer/seller have a
surplus of (0) => Social Surplus is simply the sum of
Consumer’s Surplus and Producer’s Surplus:
SS  CS  PS  (rb  p)  ( p  rs )
 rb  rs
 In the example above: SS  rb  rs  22  12  10
 “Price” complete drops out of the expression for
Social Surplus.
 “Price at which trade takes place” is critical for
determining how the “gains from trade” are “split”
between the trading partners, but does not influence
the magnitude of Social Surplus whatsoever.
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Recall the market equilibrium outcome…
Only “stable price” is at the intersection of the demand
curve and the supply curve.
price
Supply
p*=30
Demand
0
quantity
0
q*=D(30)=S(30)=55
Noted that the equilibrium in the model of Supply and
Demand is:
 “stable” (if we are there we will stay there, unless
outside forces change; but this had to be true by the
definition of equilibrium)
 “unique” (there is one and only one equilibrium, a
property which follows from the “Law of Demand”
and “Law of Supply”)
 “self enforcing” (at higher prices there is downward
pressure on price; at lower prices there is upward
pressure on price – therefore if we start at any other
price, we will be pushed toward the equilibrium price)
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But is it a “desirable outcome”? What is the “best level of
trade” for society?
One way to begin to address this question is by comparing
the “Total Social Surplus” at the market equilibrium to the
“Total Social Surplus” at other levels of trade…
 Total Social Surplus – a measure of the total gains from
trade, defined as the sum of Total Consumers’ Surplus
and Total Producers’ Surplus in the market.
 Total Consumers’ Surplus – a measure of the total
gains from trade realized by consumers, defined as the
difference between buyer’s reservation price and actual
price paid added over all units purchased.
 Total Producers’ Surplus – a measure of the total gains
from trade realized by sellers, defined as the difference
between actual price received and seller’s reservation
price added over all units sold.
Recall, Social Surplus realized from trading one particular
unit: SS  CS  PS  (rb  p)  ( p  rs )  rb  rs .
 In order to maximize “Total Social Surplus,” which units
should be traded and which units should not be traded?
 Do trade all units for which (rb  rs )  0 (or equivalently
rb  rs )
 Do not trade any units for which (rb  rs )  0 (or
equivalently rb  rs )
 Total Social Surplus is maximized by trading all units
and only those units for which buyer’s reservation
price exceeds seller’s reservation price
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price
Supply
Maximum
possible Social
Surplus
Demand
0
quantity
0
qe
qe
“Social Surplus
Maximizing” or
“Efficient” Level of Trade
q* ?
How does
compare to
That is, how does the
equilibrium level of trade compare to the efficient level?
 The “Equilibrium Quantity of Trade” is “Efficient”
in the sense that it maximizes Total Social Surplus
(i.e., total gains from trade).
 Any other level of trade is “Inefficient” in the sense
that Total Social Surplus is not as large as possible.
 Any other level of trade (either higher or lower) leads
to a smaller realized value of Total Social Surplus.
Note: to say that “free markets” are “efficient” is a bit of a
simplification. In practice, several conditions must be met
for this to be true, including: there must be many buyers
and sellers in the market; information must be available at
low cost; there cannot be any “external effects” associated
with production/consumption of the good.
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Deadweight Loss (DWL) – the difference between the
“maximum possible level of Total Social Surplus” and
the “realized level of Total Social Surplus.” DWL is
zero at the efficient level of trade; DWL is positive at all
other levels of trade.
Inefficiency from “too little trade”:
price
Realized Social
Surplus equal to
“orange area”
DWL
Supply
Demand
quantity
0
0
Level of Trade below
“Efficient Level”
Inefficiency from “too little trade” – there are some units
that we do not trade for which buyer’s reservation price is
greater than seller’s reservation price (i.e., we do not trade
all of the units we should trade).
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Inefficiency from “too much trade”:
price
Realized Social
Surplus equal to
“orange area minus
black area”
DWL
Supply
Demand
0
quantity
0
Level of Trade above
“Efficient Level”
Inefficiency from “too much trade” – we trade some
units for which seller’s reservation price is greater than
buyer’s reservation price (i.e., we trade some units that we
should not trade).
Open-ended fallacy – the logical error whereby someone
incorrectly concludes that simply because there are benefits
(to some people) from higher levels of an activity, that
more of the activity is always better
Important to recognize that
 the socially best level of trade of any good is finite
 direct result of scarcity of resources => tradeoffs exist in
regards to levels of production of different goods
 to maximize Total Social Surplus, appropriately compare
and balance marginal benefits for society against
marginal costs for society (exactly as suggested by CostBenefit Principle)
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Finally, notice that the discussion of “deadweight loss” and
the “efficient level of trade” made no mention of “price.”
 While price does not play any role in determining the
“total gains from trade,” it is of critical importance in
specifying how the “total gains” are “split” between
buyers and sellers.
“Equilibrium Price” serves to define the “split” of “total
gains from trade” between buyers and sellers under the
market equilibrium outcome:
price
Equilibrium
Price
Total
Consumers’
Surplus
(“green area”)
Supply
Total Social Surplus
(“green area” plus
“purple area”)
Total Producers’ Surplus
(“purple area”)
Demand
0
quantity
0
“Efficient” Level of Trade,
as well as “Equilibrium”
Level of Trade
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