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Economics questions for Unit 3, page 71, numbers 4 and 5 Kaiya Yamada Sept. 21, 2012 4. Using a diagram, explain the concept of community surplus. Community surplus is the welfare of society, and it is made up of consumer surplus plus producer surplus. It refers to the total surplus that both producers and consumers experience when they reach a market clearing price. Equation: Community Surplus = Consumer Surplus + Producer Surplus Consumer Surplus: Consumer surplus is the benefit consumers receive when they pay a price below what they are willing to pay. On the graph the consumer surplus is the area (B) between the demand curve and the market price (P). The consumer surplus can be calculated as the difference between what consumers are willing to pay and the market price they actually pay. A decrease in price will increase consumer surplus and an increase in price will decrease consumer surplus. Producer Surplus Producer Surplus is the benefit producers receive when they receive a price above the one at which they were willing to supply a good. On the graph the producer surplus is the area(E) between the supply curve and the market price(P). The producer surplus can be calculated as the difference between the prices of what producers actually receive for a good and what they are willing to provide a good for. A decrease in price will decrease producer surplus and an increase in price will increase producer surplus. Community Surplus: Putting consumer surplus and producer surplus together, we can see the community surplus on the graph. To calculate the community surplus, we have to calculate the consumer surplus and the producer surplus and add them together. Consumer surplus = Area of the yellow triangle ! Area=! 𝑏ℎ ! =! (5)(5) =$12.5 Producer Surplus=Area of the blue triangle ! Area=! 𝑏ℎ ! =! (5)(5) =$12.5 Community Surplus= Consumer Surplus + Producer Surplus = $12.5 + $12.5 = $25 Therefore, community surplus is $25. Community surplus is maximized at market equilibrium where supply is equal to demand and MB=MC=P. The easiest way to say it is where P=MC. Please see the graph for question 5 for the explanation of why community surplus is not maximized when marginal cost is greater than or less than marginal benefit. 5. Describe the concept of allocative efficiency and explain why it is achieved at the competitive market equilibrium. Allocative efficiency refers to the efficiency with which markets allocate resources. Allocative efficiency occurs when it is impossible to improve the overall economic welfare by reallocating resources. The best allocation of resources is at competitive market equilibrium where community surplus (consumer surplus+producer surplus) is maximized. This means that the marginal benefit and marginal cost are equal. Marginal benefit is the additional utility or satisfaction derived by an increase or a decrease in the amount of an item consumed or an activity enjoyed. Marginal cost is the increase in total cost of producing an extra unit of output. To put it another way, allocative efficiency occurs at market equilibrium and market equilibrium is where the demand equals the supply and there are no shortages or surpluses. Basically the demand curve is a measure of the marginal benefit to the consumer. The demand curve measures the maximum price consumers are willing to pay for a given quantity of a good. The supply curve is a measure of the marginal cost to the producer. The supply curve shows the maximum producers are willing to supply at that price. Allocative efficiency is at an output level where the price equals the marginal cost of production. This is because the price consumers are willing to pay is equal to the marginal utility they get. Optimal distribution is achieved when marginal utility of a good equals marginal benefit. Basically it is where MC=MB, and since it is the output level where MB=P we can say that it is where MC=P. At equilibrium the maximum willingness to pay by the consumer equals the minimum acceptable price of the supplier. The total of the consumer and producer surplus is maximized. Looking at the graph we see that market equilibrium is at Q0 and P. This is where supply is equal to demand and marginal cost is equal to marginal benefit. There are no shortages or surpluses and community surplus is maximized. (The black areas would not be there). Resources are efficiently allocated. If more is supplied than demanded as in Q1 on the graph there will be a surplus. Supply and demand will not be in equilibrium. Supply exceeds demand. Marginal costs will exceed marginal benefit and resources will not be effectively allocated. Community surplus will not be maximized. The black triangle on the right side of the graph shows the deadweight loss from consumer and producer surplus here. Here the price consumers pay for a product is less than the marginal cost of the firms producing the product so a message is sent to the producer that less output is demanded so fewer resources will be allocated to the production of the product until marginal cost is equal to the price and of course the marginal benefit. It would be in the best interests of society to decrease the supply and cut marginal costs here. If less is supplied than demanded at Q2 on the graph there will be a shortage. Supply and demand are not in equilibrium. Demand exceeds supply. Marginal benefits exceed marginal costs and resources are not effectively allocated. Community surplus will not be maximized. The black triangle on the left side of the graph shows the deadweight loss from consumer and producer surplus here. Here the price consumers pay for a product is greater than marginal costs of firms producing it (basically the benefits attained by the consumer from consumption of another unit of good or service exceeds the opportunity cost of the allocation of an additional input into the production of the good) so the message is sent to producers that more output is demanded so more resources will be allocated to the production of the product until the marginal cost and price are equal and the marginal benefit will be equal too. It would be in the best interests of society to increase the supply. All of this shows that allocative efficiency is achieved at market equilibrium because this is where supply equals demand and there are no surpluses or shortages so resources are efficiently allocated. To put it another way allocative efficiency occurs at market equilibrium and market equilibrium is where MB=MC=P. Market equilibrium shows that we can’t improve the overall economic welfare by reallocating resources. Consumer and producer surplus are maximized.