Market Efficiency

Consumer surplus and producer surplus are the basic tools that economists use to study the welfare of buyers and sellers in a market. These tools can help us address a fundamental economic question: Is the allocation of resources determined by free markets desirable?

The Benevolent Social Planner:

To evaluate market outcomes, we introduce into our analysis a new, hypothetical character called the benevolent social planner. The behavior social planner is an all-knowing, all-powerful, well-intentioned dictator. The planner wants to maximize the economic well-being of everyone in society. What do you suppose this planner should do? Should he just leave buyers and sellers at the equilibrium that they reach naturally on their own? Or can he increase economic well-being by altering the market outcome in some way.

To answer this question, the planner must first decide how to measure the economic well-being of a society. One possible measure is the sum of consumer and producer surplus, which we call total surplus. Consumer surplus is the benefit that buyers receive from participating in a market, and producer surplus is the benefit that sellers receive. It is therefore natural to use total surplus as a measure of society’s economic well-being.

To better understand this measure of economic well-being, recall how we measure consumer and producer surplus. We define consumer surplus as

Consumer surplus = Value to buyer – Amount paid by buyers.

Similarly we define producer surplus as

Producer surplus = Amount received by sellers – Cost to sellers.

When we add consumer and producer surplus together we obtain,
Total surplus =
Value to buyers – Amount paid by buyers + Amount received by
sellers — Cost to sellers

The amount paid by buyer equals the amount received by sellers, so the middle two terms in this expression cancel each other.

If allocation of resources maximize total surplus, we say that the allocation exhibits efficiency. If an allocation is not efficient then some of the gains from trade among buyers and sellers are not being realized. For example, an allocation is inefficient if a good is not being produced by the sellers with lowest cost. In this case, moving production from a high-cost producer to a low cost producer will lower the total cost to sellers and raise total surplus. Similarly, an allocation is inefficient if a good is not being consumed by the buyers who value it most highly. In this case, moving consumption of the good from a buyer with a low valuation to a buyer with a high valuation will raise total surplus.

In addition to efficiency, the social planner might also care about equity – the fairness of the distribution of well-being among the various buyers and sellers. In essence, the gains from trade in a market are like a pie to be distributed among the market participants. The question of efficiency is whether the pie is as big as possible. The question of equity is whether the pie is divided fairly. Evaluating the equity of a market outcome is more difficult that evaluating the efficiency is an objective goal that can be judged on strictly positive grounds, equity involves normative judgments that go beyond economic an enter into the realm of political philosophy.

In this article, we concentrate on efficiency as the social planner’s goal. Real policymakers often care about equity as well. They care about both the size of the economic pie and how the pie gets sliced and distributed among members of society.

Evaluating the market equilibrium:

Recall that consumer surplus equals the area above the price and under the demand curve and producer surplus equals the area below the price and above the supply curve. Thus, the total area between the supply and demand curves up to the point of equilibrium represents the total surplus in this market.

When a market is in equilibrium, the price determines which buyers and sellers participate in the market. Those buyers who value the good more than the price choose to buy the good; buyers who value it less than the price do not. Similarly those sellers whose costs are less than the price choose to produce and sell the good; sellers whose costs are greater than the price do not.

These observations lead to two insights about market outcomes:

1. Markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay.
2. Free markets allocate the demand for goods to the sellers who can produce them at least cost.

Thus, given the quantity produced and sold in a market equilibrium, the social planner cannot increase economic well-being by changing the allocation of consumption among buyers or the allocation of production among sellers.

3. Free markets reduce the quantity of goods that maximizes the sum of consumer and producer surplus.