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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