This article introduced the basic tools of welfare economies — consumer and producer surplus – and used them to evaluate the efficiency of free markets. We showed that the forces of supply and demand allocate resources efficiently. That is even though each buyer and seller in market is concerned only about his or her own welfare they are together led by an invisible hand to an equilibrium that maximizes the total benefits to buyers and sellers.
A word of warming is in order. To conclude that markets are efficient we made several assumptions about how markets work. When these assumptions do not hold, our conclusion that the market equilibrium is efficient may no longer be true. As we close this article let’s consider briefly two of the most important of these assumptions.
First, our analysis assumed that markets are perfectly competitive. In the world, however competition is sometimes far from perfect. In some markets, a single buyer or sellers (or a small group of them) may be able to control market prices. This ability to influence prices s called market power. Market power can cause markets to be inefficient because it keeps the price and quantity away from the equilibrium of supply and demand.
Second, our analysis assumed that the outcome in a market matters only to the buyers and sellers in that market. Yet, in the world the decisions of buyers and sellers sometimes affect people who are not participants in the markets at all. Pollution is the classic example of a market outcome that affects people not in the market Such side effects called externalities cause welfare in a market to depend on more than just the value to the buyers and the cost to the sellers Because buyers and sellers do not take these side effects into account when deciding how much to consume and produce the equilibrium in a market can be inefficient from the stand point of society as a whole.
Market power and externalities are examples of a general phenomenon called market failure – the inability of some unregulated markets to allocate resources efficiently. When market fail public policy can potentially remedy the problem and increase economic efficiency. Micro economists devote much effort on studying when market failure is likely and what sorts of policies are best at correcting market failures. As you continue your study of economies you will see that the tools of welfare economics developed here are readily adapted to that endeavor
Despite the possibility of market failure the invisible hand of the market place is extraordinarily important. In many markets, he assumptions we made in this chapter work well and the conclusion of market efficiency applies directly. Moreover our analysis of welfare economics and market efficiency can be used to shed light on the effects of various government policies. In the next section, we apply the tools we have developed to study tow important policy issues – the welfare effects of taxation and of international trade.
Consumer surplus equals buyers’ willingness be pay for a good minus the amount they actually pay for it, and it measures the benefit buyers get from participating in a market. Consumer surplus can be computed by finding the area below the demand curve.
Producer surplus equals the amount sellers receive for their goods minus their costs of production, and it measures the benefit sellers get from participating in market. Producer surplus can be computed by finding the area below the price and above the supply curve.
Ana allocation of resources that maximizes the sum of consumer and producer surplus is said to be efficient. Policymakers are often concerned with the efficiency as well as the equity of economic outcomes.
The equilibrium of supply and demand maximizes the sum of consumer and producer surplus. That is, the invisible hand of the marketplace leads buyers and sellers to allocate resources.
Markets do not allocate resources efficiently in the presence of market failures such as market power or externalities.