Chapter 8: Market efficiency (1.

1)
Key concepts:
Consumer surplus
Producer/supplier surplus
Allocative efficiency
Total surplus: societal surplus
Deadweight loss
Pareto optimum

Markets are considered to have done the job when equilibrium price and quantity is achieved the market has
cleared, leaving on excess demand or supply. In other words, the price mechanism has seen to it that resources have
been allocated to the right areas and consumers are paying the right price for the correct amount of goods. 1

A more correct way of putting it in economic jargon is that the marginal benefit to consumers (quantity demanded at equilibrium) is equal to
the marginal cost (quantity supplied at equilibrium) of producing the goods. This will be dealt with in Chapter 16.

Intro questions:
A market price of $10 means that all customers in effective demand are getting a good deal.
Explain.
_____________________________________________________________________________
_____________________________________________________________________________
Fill in. When a producer is able and willing to sell 1,000 units at a price of $5 but is getting a
price of $10, he/she is getting_________ worth of _______________.
Fill in. At any price other than Pmkt, there is _______________ of resources. When the price is
below Pmkt, there will be an ________ of _________. Consumer surplus (CS) and producer
surplus (PS) are not ______________, so there is ____-_________ resource allocation.
An expenditure tax on a good _______ supply and _____ the price this means that CS and PS
_______. The area of tax revenue is not the same as the total loss of _____ and _____. There is
thus a ________________________ to society.
The sum of the NET loss of CS and PS is ________________________
If the sum of CS and PS is optimal in all sectors in society, we must have a situation known in
economics as _____________________________ .
Think ahead! If taxes indeed lower CS and SS, how is it possible to say that in some cases the
tax leads to better resource allocation?! (Hint; look up negative externalities and then give
your answer.)
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
_____________________________________________________________________________
What effect will an increase in demand for a good have on CS and SS?
_____________________________________________________________________________
_____________________________________________________________________________

Consumer surplus
Areas A to E: Lets say that 100 people walk in to buy a jacket and are prepared to pay a price of 200 and
the market price is 150. This group gets a marginal utility of areas A, B, C, D and E; 100 units time 50.

Areas F to I: If 200 people buy a jacket each, the first group of 100 people (Group A to E) will receive a
surplus benefit (i.e. pay a price below the value they place on the item) of 50 each. The second group, F to
I, is prepared to pay 190 yet also pay the market price of 150. The consumers in this group thus receive a
surplus of 40 each.

<definition>
Consumer surplus: Consumer surplus is the additional benefit (marginal utility) received by a consumer in
purchasing a good where the market price is less than he/she would be willing to pay. Total consumer surplus is the
area above the market price but below the demand curve.
<end definition>
Figure 8.1 Consumer and supplier surplus

Price (/jacket)
Market for jackets

210
200
A
190
B F
180
170
160
150

C G
E

V IX

III VII

120
II VI
110
I
100
I
90

P ()

D H

140
IV VIII
130

Consumer surplus

1 2 3 4 5
6 7
Quantity (100s jackets/week)

Producer/supplier surplus

D
Q

Supplier surplus

Q/t

Areas I to V: The supply curve in figure 8.1 shows that suppliers would be willing/able to put 100 jackets
on the market at a price of 100. At the market price of 150 the revenue per jacket received is 50 above
the marginal cost of producing these 100 jackets. Areas I, II, III, IV and V show the supplier surplus, i.e.
the total additional marginal revenue above and beyond what suppliers would be willing/able to put on the
market for the first 100 jackets.

Areas VI to X: At an even higher price of 110, producers add an additional 40 of surplus, areas VI to
IXand so on up to the market clearing price of 150, At a market price of 150, producers receive a total
supplier surplus of the blue triangle in the diagram on the right.

<definition>
Producer/supplier surplus: Producer or supplier surplus is the additional benefit (revenue) received by a
producer in selling a good where the market price is above what the producer would be willing to accept. (HL: this
is in fact marginal cost. More in Chapter 23.) Total supplier surplus is the area above the supply curve and below
the market price.
<end definition>

Allocative efficiency
The perfectly competitive market at equilibrium price will maximise both consumer and supplier surplus, leading to
an optimal allocation of resources. Any action which reduces this total surplus (also known as community or
societal surplus) renders an allocatively suboptimal outcome. (See for example Monopoly)
o Deadweight loss
While HL will go into the issue of deadweight loss in Chapter 13, it is such a useful concept that I introduce the
basic concept here for SL. Having said the above about maximum societal surplus when free market forces rule, it
is also possible for society to incur (= acquire) an overall avoidable loss of societal surplus. Government
intervention such as a tax on goods sold can result in lower overall societal surplus, as can imperfect competition
such as monopolies. In the case outlined in figure 8.3, the tax is shown by the double-edged red arrow and the
change in price is from P0 to P1 half the tax.
Figure 8.3 Tax on goods sold (expenditure tax) and deadweight loss

Remaining
consumer surplus

P (/pen)

Tax per pen

S
P1
P0
P*

A
C

B
D

D1
Q1 Q0

A + B: loss of
consumer
surplus due to
tax

Q/t (pens/year)

B
D

C + D; loss of
supplier surplus
due to tax

A: govt tax
revenue paid
by consumers

A
C

C: govt tax
revenue paid
by suppliers

B: net loss of
consumer
surplus

Sum of the net

losses of
consumer
surplus and
supplier surplus
= deadweight
loss

B
D

D: net loss of
supplier
surplus

Remaining supplier
surplus

The tax decreases the quantity demanded and supplied from Q0 to Q1

Consumers pay more (P0 to P1) but suppliers earn less (P0 to P*) since they have to pay the tax of P* to P1
shown by the red double-edged arrow
Total tax revenue to government is the tax per unit (P* to P1) times the quantity (Q1) e.g. areas A and C
Since consumers are paying more for less then there must be a loss of consumer surplus this is shown by
areas A and B
Suppliers are receiving less for less which is a loss of supplier surplus areas C and D
Total loss of supplier surplus and consumer surplus, societal surplus, are areas A + B + C + D
However, government is part of society just like firms and consumers this total (gross) loss of societal
surplus is to an extent offset (= compensated) by the increase in government revenue of A + C
The two areas of societal surplus lost which are not offset by governments gain (tax revenue) are areas B
and D this net loss of societal surplus is the deadweight loss due to the expenditure tax on pens

<definition>
Deadweight loss: A deadweight loss is an efficiency loss to society since societal surplus is decreased without a
corresponding gain for another actor in society. It is the net loss of consumer surplus and supplier surplus.
<end def>
o Pareto optimum
The concept of societal efficiency in an economy was pioneered by the Italian/French social-economist Wifredo
Pareto (1848 1923) and is often explained using a PPF for supporting illustration. For once, I shant be different.
Societal efficiency is said to be maximised when the economy is operating on the PPF; anything else would mean
that resources are not being used to the utmost. The PPF in figure 8.4 shows an economy where output is divided
into goods for IB teachers2 (such as TOK books and comfortable shoes) and IB students (Nintendo games and
marshmallows).
2

There are so many things Id love to put herebut my editor wont let me. Feel free to write to me with suggestions!

Fig. 8.4 Pareto optimum

Goods for IB
teachers
D

C
B
A

PPF

When all available

resources are fully
employed,
increasing output of
teachers goods
means taking
resources away
from producing
students goods.
Each point on the
PPF is a Pareto
optimum point of
output.

Goods for IB
students

At point A, the economy is maximally efficient and it is impossible to increase teachers goods without decreasing
output of students goods and vice versa. Therefore, anywhere along the PPF, the economy can be said to be
optimally societally efficient. This is referred to as a Pareto optimum. The condition is put as a conditional phrase:
If it is impossible to increase the well-being of one person [here IB teachers] without making someone else [IB
students] worse off, then the economy is at a Pareto optimum. Note that Pareto optimality in no way suggests the
best point of output, only that points A to D fulfil the criteria for optimal efficiency.
<definition>
Allocative efficiency: When consumer and supplier surplus societal surplus is maximised across all markets,
then it is impossible to make consumers of Good X better off without making consumers of Good Y worse off.
Resources are allocated in such a way that net benefits are maximised. This is allocative efficiency.
<end def>

Summary and revision (need a cool pic here.maybe a pic of someone doing pushups!)
The price consumers are willing/able to pay minus the de facto market price is the
consumer surplus for a consumer.
The market price a supplier receives for a unit of goods minus the minimum price the
supplier demands for putting that unit on the market is supplier or producer surplus.
The sum of consumer and supplier surplus is societal (or community) surplus.
When the market is in equilibrium there is no excess in supply or demand so the use of
(scarce) resources is optimised. This is allocative efficiency.
Any form of market distortion which leads to a net loss of societal surplus is a deadweight
loss to society. This means that there is allocative inefficiency.
If all resources are used to the maximum then the economy would be on the PPF. It is thus
impossible to make consumers of Good X better off without making consumers of Good Y
worse off. This is known as Pareto optimum and is another way of defining optimal
allocative efficiency.