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Chapter 8: Market efficiency (1.1)
Key concepts:
 Consumer surplus

Producer/supplier surplus

Allocative efficiency
o Total surplus: societal surplus
o Deadweight loss
o 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
 Consumer surplus
I always enjoy this part of the syllabus in class as it lends itself very easy to students’ own experiences and
intuitiveness. I ask you too to imagine walking by a store window on the way to school every day, and seeing a
really nice jacket that you just must have. It’s expensive, €180, so you save for a few months. One day you walk in
with your wad of money to buy the jacket, and it turns out that you have just hit the sales! The jacket ‘only’ costs
€150. You buy it and enjoy the additional pleasure of having been prepared to pay €180 but not having to do so.
You get a ‘surplus’ valued at €30, i.e. an enjoyment above and beyond what you paid for. You got €180 worth of
marginal utility for €150.2 This is consumer surplus.
Let’s assume a local market for jackets and that each potential customer only wants one jacket and that demand is
zero at a price of €210. Figure 8.1 illustrates how consumer surplus is summed up.

Areas A to E: Let’s 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.
At the market price of €150, total consumer surplus is shown by the fifteen shaded squares. And as prices in fact do
not move in increments of €10, but can theoretically move ‘one cent at a time’, total consumer surplus in the entire
orange shaded triangle above the market price, shown in the diagram on the right. Conclusion: At a market price of
€150, a possible 599 people are getting ‘more than they pay for’, i.e. receive consumer satisfaction valued at more
than the market price. The concept of consumer surplus tells us that all economic transactions are of value to
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.
2
Now think; why are post-Christmas sales so enjoyable?!
participants on the consumption side – otherwise they would not take place. Any intervention (= non-market force)
on a market which diminishes consumer surplus has a negative effect on both consumers and allocative efficiency.
<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
Consumer surplus
P (€)
S
S
D H
E
I
P
V IX
140
IV VIII
130
III VII
120
II VI
110
I
100
I
90
0
D
D
Q
Q/t
Supplier surplus
1 2 3 4 5
6 7
Quantity (100s jackets/week)
 Producer/supplier surplus
Suppliers providing goods at the market price also receive a surplus; the price which is above and beyond the price
at which certain suppliers would be willing (and able) to provide the good at.

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
IX…and 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.
In summa: As with consumer surplus, if the transaction takes place, then there is a marginal benefit for the supplier.
<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 Maximum societal (community) surplus
If pure market forces have resulted in equilibrium in all markets, then the societal surplus will be maximised. Skim
back and revise the example of the price mechanism and resource allocation in Chapter 7 (figure 7.2). The increase
in demand for red pens meant that resources were re-allocated to red pens as in figure 8.2 below.
Figure 8.2 Re-allocation and societal surplus
a) Red pens
a) Green pens
Increased societal
surplus after resources
are re-allocated to red
pens.
P (€/pen)
P (€/pen)
Lower societal surplus after
resources are re-allocated to red
pens.
S1
S
S0
P1
P1
P0
P0
D1
D1
D0
q0
q1
Q/t (pens/year)
An increase in demand for red
pens (D0 to D1) increases both
consumer and supplier surplus (=
societal surplus)
Q1 Q0
Q/t (pens/year)
An decrease in supply for red pens
(S0 to S1) decreases both consumer
and supplier surplus (= societal
surplus)
The basic point here is that both periods are allocatively efficient! Before the demand for red pens increased, both
markets were optimally efficient – there was no excess supply or excess demand. After demand for red pens
increased and resources were re-allocated for green to red pens, societal surplus is still maximised given the
limitations of scarcity in resources. Again, the question of “…which is the best combination of quantity of
goods…” isn’t the issue. The issue is how the price mechanism in a freely competitive market serves to allocate
resources in such a way as to optimise use of available resources.
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.
Instead of producers voluntarily reducing the supply of green pens in order to re-allocate resources to red pens,
assume that the government instead levies (= puts) a tax on pens sold, e.g. an expenditure tax. Since a tax on goods
sold by firms is an indirect tax (consumers do not pay the tax to government but to suppliers who in turn pay the tax
on to government) suppliers will have to decide how much of the tax they can get consumers to pay.3 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
A + B: loss of
consumer
surplus due to
tax
A: govt tax
revenue paid
by consumers
B: net loss of
consumer
surplus
S
Sum of the net
losses of
consumer
surplus and
supplier
surplus =
deadweight
loss
P1
P0
A
C
A
B
D
C
P*
D1
Q1 Q0
Q/t (pens/year)
B
D
C + D; loss of
supplier surplus
due to tax
A
C
C: govt tax
revenue paid
by suppliers
B
D
D: net loss of
supplier
surplus
Remaining
supplier surplus
If consumers are paying half the tax then the other half must come from suppliers. (This makes perfect sense;
suppliers evidently did not impose the full tax on consumers but are taking half of the tax they need to hand over to
government out of their own pockets.) Let us follow the “flow” from the tax to the deadweight loss:

3
The tax decreases the quantity demanded and supplied from Q0 to Q1
This deals with the price elasticity of demand covered in Chapter 9. Exciting, no?!







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 government’s 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
The tax creates a market distortion since both consumers and suppliers would have benefitted from consuming and
selling Q0 rather than Q1. Every pen sold/consumed between Q1 and Q0 would add to overall societal surplus but
the tax prevents these transactions from taking place. Since these lost units do not result in tax revenue going to
government, society is worse off.
Many of my students find the concept of deadweight loss rather frustrating and difficult to intuitively grasp. “Yeah,
but where do areas B and D go?!” Well, they go “poof”. Disappear. “But WHERE?!” This can go on for a long
time. Then I tell the story of losing one’s wallet in the forest. If I lose a wallet with $200 in it but somebody else
finds it, then society is in fact just as well off since my loss has been offset by someone else’s gain. However, if I
lose the wallet and $20 is eaten by hungry squirrels and then is found, my loss is not entirely offset by someone
else’s gain. The $20 went “poof”. This is the net loss of consumer surplus.4
<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 shan’t 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 teachers5 (such as TOK books and comfortable shoes) and IB students (Nintendo games and
marshmallows).
Fig. 8.4 Pareto optimum
“….hrrrrrrrrrrnggggggggrrrrrr…BUT WHERE DOES THE DEADWEIGHT LOSS TRIANGLE GOOOOOOO…?!” “Look guys, it goes
“POOF”! It is an ex-triangle! It is pushing up daisies! Gone to the Happy Triangle Hunting Grounds! It is no more! Extinct! Hasta la vista
baby! Croaked! Stuck its spoon in the wall! Toe-tagged! Living-impaired!” I am not paid enough for this.
5 There are so many things I’d love to put here…but my editor won’t let me. Feel free to write to me with suggestions!
4
Goods for IB
teachers
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.
D
C
B
A
PPF
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!)
1. The price consumers are willing/able to pay minus the de facto market price is the
consumer surplus for a consumer.
2. 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.
3. The sum of consumer and supplier surplus is societal (or community) surplus.
4. 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.
5. 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.
6. 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.