Efficiency in Competitive
Markets
What is the difference between consumer and
producer surplus?
What is the role of the price mechanism in a market?
Where is the best allocation of resources found? What
is this called?
Why is social surplus important?
Remember
• Changing prices convey information:
• increase=producers will produce more (signals
excess demand); consumers will consume less
• decrease= consumers will consume more;
producers will produce less (signals excess
supply)
• The change in the behavior of market
participants leads to a change in price and
thus more/less production. A change in the
allocation (distribution) of resources follows.
Review:
• What is efficiency?
– Efficiency is making the best possible use of resources
• How can economists show production in a market,
ceteris paribus?
– Using a production efficiency model, called the production
possibilities curve/frontier (PPC/PPF)
• Why does it matter if production is efficient?
– Resources are scarce, so efficiency in production means that
you can maximize production at the least cost
Allocative efficiency
• Allocative efficiency is a more precise term for
efficiency—it refers to the economy allocating
(distributing) its resources so that benefits from
consumption are maximized for all of society
• If allocative efficiency is achieved, then
productive efficiency is also achieved, where
output is produced by use of the fewest possible
resources (lowest possible cost)
Why does that matter?
• Think about it: Why can’t we have allocative
efficiency for a society without having productive
efficiency as well?
• If there was any productive inefficiency at all in
the economy, it would not be possible to have
allocative efficiency.
– Inefficiency: firms are not using fewest possible
resources for production (not lowest cost)
– There would have to be a process of getting rid of
inefficient firms and reallocating resources to efficient
ones
– Hence, some people become better off from
consumption while others become worse off.
How is efficiency achieved?
• Through consumer and producer surplus
• Consumer surplus: the highest price
consumers are willing to pay for a good, minus
the price actually paid.
– (the difference between what the consumer has to
pay for a good and the amount he/she is willing to
pay)
– In a competitive market, price paid is determined at
equilibrium by supply and demand for the good.
• Consumer surplus indicates that though some
are willing to pay a higher price to get the good,
they actually received it for less.
Consumer surplus
• Consumer surplus
represents the
difference between
benefits consumers
receive (marginal
benefits) and the
price paid to receive
them
• It is the area under the
demand curve &
above the price.
Calculating consumer surplus
•
Since the demand
curve is above the price
at points to the left of
Q* each of these
purchases results in
surplus.
•
When P* intersects the
demand curve, there is
no surplus, and to the
right of Q* consumers
are not willing to pay
the price.
•
So in the graphical
example, we would
have to calculate the
area of a triangle which
is equal to
½(base*height).
Practice!
• Turn to the first
worksheet
• With a partner,
complete the
consumer surplus
practice problems
• We’ll discuss in 10
minutes.
How is efficiency achieved?
• Through consumer and producer surplus
• Producer surplus: the price received by firms
for selling their good, minus the lowest price they
are willing to accept to produce the good
– (the difference between what the producer receives
for the good and the amount he/she must receive to
be willing to provide the good)
– In a competitive market, price received is determined
at equilibrium by supply and demand for the good.
Producer Surplus
• Producer surplus
represents the
firms’ cost of
producing an extra
unit of the good
(marginal cost,
MC)
– Lowest price willing
to accept is just
enough to cover
cost of producing
extra unit (MC)
• It is the area above
the supply curve &
below the price
received by the firm.
Calculating producer surplus
• Most of the time, the
supply curve will
intersect the price
and quantity axis at
the origin (0,0).
• This means that
calculating producer
surplus is somewhat
easier, as less math
is involved.
• In order find producer
surplus we need to
calculate the area of
a triangle, remember
that the area of a
triangle is:
½(base*height).
Practice!
• Turn to the second
worksheet
• With a partner,
complete the
producer surplus
practice problems
• We’ll discuss in 10
minutes.
Social surplus
• The best allocation of
resources from
society’s point of view
is at competitive market
equilibrium. Why?
• Social surplus
(consumer+producer
surplus) is maximized at
equilibrium, since
marginal
benefit=marginal cost at
this point.
Important!
• At the point of competitive market
equilibrium, production of a good occurs
where MB=MC
– This is called social surplus
– This is also where consumer surplus plus
producer surplus is maximum
– SO markets are therefore achieving
allocative (and productive) efficiency
Important!
• When competitive markets realize
allocative efficiency, economists also call
this “social welfare maximization”
• Welfare in this sense is the general wellbeing of society
– Social welfare maximization then means that
there is maximum social surplus, MB=MC
– Be careful with this generalization (see p. 4445 in your text)
Final thoughts
• Producer and consumer surplus review
video
• Cartoon review of consumer surplus