Question

Suppose that purely competitive firms producing cashews discover that \(P\) exceeds MC. Is their combined output of cashews too little, too much, or just right to achieve allocative efficiency? In the long run, what will happen to the supply of cashews and the price of cashews? Use a supply and demand diagram to show how that response will change the combined amount of consumer surplus and producer surplus in the market for cashews.

Short answer

The output is too little; supply will increase, and price will fall in the long run, increasing consumer and producer surplus.

Step-by-step solution

Understanding Allocative Efficiency

Allocative efficiency occurs when the quantity of goods produced is socially optimal, meaning that the price (P) equals the marginal cost (MC) of production. This condition ensures that resources are being used where they are most valued by society.

Analyzing the Condition

In this scenario, the price (P) of cashews exceeds the marginal cost (MC). This indicates that firms are producing less than the socially optimal quantity because consumers value additional units more than it costs to produce them.

Impact on Output

Since P > MC, the combined output of cashews is too little to achieve allocative efficiency. Firms should increase production to the point where P equals MC to reach the optimal allocation of resources.

Long-Run Supply and Price Adjustments

In the long run, the higher price (P > MC) is a signal to firms to enter the market, leading to increased supply. As supply increases, the price will decrease until P equals MC, achieving allocative efficiency.

Supply and Demand Diagram

Draw a supply and demand diagram with the initial equilibrium where P > MC (initial supply curve). Show an increase in supply (shift of the supply curve to the right). As supply increases, price falls until it equals MC, and output increases to the optimal level.

Changes in Consumer and Producer Surplus

Initially, surplus is not maximized because output is too low. As supply increases and price falls, the quantity of cashews produced and consumed increases, leading to an increase in both consumer surplus (due to lower prices) and producer surplus (due to larger quantities sold, assuming costs are constant).

Key concepts

Marginal Cost

Marginal cost (MC) is a fundamental concept in economics that represents the additional cost of producing one more unit of a good or service. It's crucial for firms when making decisions about the level of production. When marginal cost is analyzed, it helps businesses understand how changes in production volume can affect overall costs.
Consider a cashew production firm deciding whether to produce an additional bag of cashews. The marginal cost would include all the extra inputs needed, such as labor and raw materials, for that one more bag. If the price (P) at which the firm can sell an additional bag is greater than the marginal cost, it’s profitable to increase production.
Understanding marginal cost is essential because it helps firms find the optimal level of production to maximize their profits. Moreover, when resources are allocated where price equals marginal cost, allocative efficiency is achieved, and this maximizes welfare in the economy.

Supply and Demand

Supply and demand form the backbone of market economies. Together, these forces determine prices and the quantity of goods and services that are produced and consumed in the market. Let's dive a bit deeper into how they work.

• Supply: This is the quantity of a good or service that producers are willing and able to sell at different price levels in a given period. An increase in price typically encourages producers to supply more because they can earn more from selling each additional unit.
• Demand: This refers to the quantity of a good or service that consumers are willing to purchase at different price levels. Generally, as the price decreases, the quantity demanded increases because more consumers find the good affordable.

The interaction between supply and demand determines the market equilibrium – the point where the amount supplied equals the amount demanded at a particular price level. If demand increases, it can push up prices until a new equilibrium is achieved. Conversely, if supply increases, perhaps due to new firms entering the market like in our cashew example, the result is often a lower price. Changes in these forces are depicted in supply and demand diagrams, pivotal tools for visualizing market dynamics.

Consumer Surplus

Consumer surplus is an important measure of consumer happiness and market efficiency. It represents the difference between what consumers are willing to pay for a good or service and what they actually pay. This surplus can be thought of as a measure of the benefit consumers receive from purchasing products at a price lower than the highest price they'd be willing to pay.
Imagine cashew lovers who expect to pay $5 for a bag but only pay $3 due to market conditions. The $2 saved by each consumer is the consumer surplus.
As the supply of cashews increases and the price falls, consumer surplus grows because many consumers are able to buy cashews at prices lower than what they were initially willing to pay. Elevated consumer surplus means that more people have access to the product at affordable prices, increasing overall consumer satisfaction and ensuring that the market is closer to allocative efficiency.

Producer Surplus

Producer surplus pertains to the benefits producers receive by selling a good at a market price higher than the minimum they would be willing to sell for. It’s akin to "producer profit" from the market standpoint and indicates the economic benefit to producers from market transactions.
Say a farmer is willing to sell cashews for $2 per bag but the market price turns out to be $3 per bag. The producer surplus is the additional $1 received per bag.
In our scenario, an increase in market supply drives down prices, but as production quantities expand, efficient producers can still thrive due to larger volumes sold, potentially maintaining or even enhancing producer surplus. Moreover, as price aligns with marginal cost in long-run equilibrium, producers efficiently utilize resources, sustaining long-term market presence and profitability. This balance is crucial for ensuring producers continue to contribute positively to a well-functioning market economy.