Module 12 Efficiency and Markets

What You Will Learn The meaning and importance of total surplus and how it can be used to illustrate efficiency in markets How taxes affect total surplus and can create deadweight loss 1 2

Total Surplus The total surplus generated in a market is the total net gain to consumers and producers from trading. It is the sum of the producer surplus and the consumer surplus. The concepts of consumer surplus and producer surplus can help us understand why markets are an effective way to organize economic activity.

Total Surplus Price of book Consumer surplus Equilibrium price Quantity of books 1,000 $30 S D Producer surplus Consumer surplus E Equilibrium price Figure Caption: Figure 12-1: Total Surplus In the market for used textbooks, the equilibrium price is $30 and the equilibrium quantity is 1,000 books. Consumer surplus is given by the blue area below the demand curve but above the price. Producer surplus is given by the pink area above the supply curve but below the price. The sum of the blue and pink areas is total surplus, the total benefit to society from the production and consumption of the good. Equilibrium quantity

The Gains from Trade The previous graph shows that both consumers and producers are better off because there is a market in this good (i.e., there are gains from trade). These gains from trade are the reason everyone is better off participating in a market economy than if each individual tried to be self-sufficient.

The Efficiency of Markets Claim: The maximum possible total surplus is achieved at market equilibrium. Market equilibrium allocates consumption of the good among potential consumers and sales of the good among potential sellers in a way that achieves the highest possible gain to society. Any change from the market equilibrium reduces total surplus.

How to Make Markets Inefficient Reallocate consumption among consumers. Take the good away from buyers who would have purchased it at market equilibrium and give it to consumers who wouldn’t have bought it at equilibrium. Reallocate sales among sellers. Take sales away from those who would have sold the good at market equilibrium and instead compel sales by producers who would not have sold the good at equilibrium. Change the quantity traded. Compel consumers and producers to transact either more or less than the equilibrium quantity.

Reallocating Consumption Lowers Consumer Surplus 1,000 30 $35 25 Price of book Quantity of books Loss in consumer surplus if the book is taken from Ana and given to Bob S D A B E Figure Caption Figure 12-2: Reallocating Consumption Lowers Consumer Surplus Ana (point A) has a willingness to pay of $35. Bob (point B) has a willingness to pay of only $25. At the market equilibrium price of $30, Ana purchases a book but Bob does not. If we rearrange consumption by taking a book from Ana and giving it to Bob, consumer surplus declines by $10, and as a result total surplus declines by $10. The market equilibrium generates the highest possible consumer surplus by ensuring that those who consume the good are those who most value it.

Reallocating Sales Lowers Producer Surplus 1,000 30 $35 25 Price of book Quantity of books S D Y X Loss in producer surplus if Yvonne is made to sell the book instead of Xavier E Figure Caption: Figure 12-3: Reallocating Sales Lowers Producer Surplus Yvonne (point Y) has a cost of $35, and Xavier (point X) has a cost of $25. At the market equilibrium price of $30, Xavier sells a book but Yvonne does not. If we rearrange sales by preventing Xavier from selling his book and compelling Yvonne to sell hers, producer surplus declines by $10, and as a result, total surplus declines by $10. The market equilibrium generates the highest possible producer surplus by ensuring that those who sell the good are those who most value the right to sell it.

Changing the Quantity Lowers Total Surplus 1,000 30 $35 25 Price of book Quantity of books Loss in total surplus if the transaction between Ana and Xavier is prevented Loss in total surplus if the transaction between Yvonne and Bob is forced S D Y X A B E Figure Caption: Figure 12-4: Changing the Quantity Lowers Total Surplus If Xavier (point X) were prevented from selling his book to someone like Ana (point A), total surplus would fall by $10, the difference between Ana’s willingness to pay ($35) and Xavier’s cost ($25). This means that total surplus falls whenever fewer than 1,000 books—the equilibrium quantity—change hands. Likewise, if Yvonne (point Y) were compelled to sell her book to someone like Bob (point B), total surplus would also fall by $10, the difference between Yvonne’s cost ($35) and Bob’s willingness to pay ($25). This means that total surplus falls whenever more than 1,000 books change hands. These two examples show that at market equilibrium, all mutually beneficial transactions—and only mutually beneficial transactions—occur.

The Efficient Market It allocates consumption of the good to the potential buyers who value it the most, as indicated by the fact that they have the highest willingness to pay. It allocates sales to the potential sellers who most value the right to sell the good, as indicated by the fact that they have the lowest cost. It ensures that every consumer who makes a purchase values the good more than every seller who makes a sale, so that all transactions are mutually beneficial. It ensures that every potential buyer who doesn’t make a purchase values the good less than every potential seller who doesn’t make a sale, so that no mutually beneficial transactions are missed.

Cost of Collecting Taxes The administrative costs of a tax are the resources used—over and above the value of the tax itself—(1) to collect it, (2) to pay it, and (3) to avoid it. The total inefficiency caused by a tax is the sum of its deadweight loss and its administrative costs. The general rule for economic policy is that other things equal, a tax system should be designed to minimize the total inefficiency it imposes on society.

Why Markets Work So Well The economy is made up of many interrelated markets. Well-functioning markets owe their effectiveness to two features: Property rights: a system in which valuable items in the economy have specific owners who can dispose of them as they choose. Economic signals: any piece of information that helps people make better economic decisions.

Why Markets Sometimes Go Wrong When markets are inefficient, production or consumption could be rearranged to make some people better off without making other people worse off.

Why Markets Sometimes Go Wrong When a market is inefficient, there is a market failure. Markets can fail when: one party prevents mutually beneficial trades. actions of individuals have side effects on the welfare of others that markets don’t take into account. goods are unsuited for efficient management by markets.

Summary In a market, total producer surplus—the sum of the individual producer surpluses—is equal to the area above the market supply curve but below the price. Total surplus, the total gain to society from the production and consumption of a good, is the sum of consumer and producer surplus. Usually, markets are efficient and achieve the maximum total surplus. Markets can fail to organize effectively because of market failures.