Question

Assume that candle wax is traded in a perfectly competitive market in which the demand curve captures buyers' full willingness to pay while the supply curve reflects all production costs. For each of the following situations, indicate whether the total output should be increased, decreased, or kept the same in order to achieve allocative and productive efficiency. a. Maximum willingness to pay exceeds minimum acceptable price. b. \(M C>M B\). c. Total surplus is at a maximum. d. The current quantity produced exceeds the market equilibrium quantity.

Short answer

a. Increase output. b. Decrease output. c. Keep output the same. d. Decrease output.

Step-by-step solution

Understanding the Market and Equilibrium

In a perfectly competitive market, allocative efficiency occurs where the market equilibrium is reached. This is where demand (willingness to pay) equals supply (production cost). The intersection point determines the equilibrium price and quantity.

Analyzing Maximum Willingness vs Minimum Price

If the maximum willingness to pay (demand) exceeds the minimum acceptable price (supply), there is room to increase total output. At this point, production and selling more goods will increase total surplus and move towards equilibrium.

Evaluating When MC Exceeds MB

When the marginal cost (MC) exceeds the marginal benefit (MB), the cost of producing an additional unit is higher than the value that consumers place on it. In this scenario, total output should be decreased to avoid wastage and reduce costs.

Assessing Maximum Total Surplus

If total surplus, which is the sum of consumer and producer surplus, is at a maximum, the market is in equilibrium. Therefore, the total output should be kept the same as it is already at the optimal level.

Determining Action When Quantity Exceeds Equilibrium

When current production exceeds equilibrium quantity, there is excess supply, leading to inefficiency. To restore equilibrium and maximize surplus, total output should be decreased to match the equilibrium quantity.

Key concepts

Allocative Efficiency

Allocative efficiency occurs when resources in a market are distributed in a way that maximizes total benefit to society. In other words, it's achieved when goods or services are produced at the level where the last unit provides a marginal benefit to consumers that is equal to the marginal cost of production. This ensures that the right amount of goods is produced for the well-being of society.
In a perfectly competitive market, allocative efficiency is reached at the market equilibrium, where the demand curve (representing consumers' willingness to pay) intersects with the supply curve (indicating producers' cost). At this point:

• The quantity of goods supplied equals the quantity demanded.
• There is no overproduction or underproduction of goods.
• Resources are utilized in the most beneficial way for society.

Therefore, if the maximum willingness to pay exceeds the minimum acceptable price, increasing production can help achieve allocative efficiency by aligning output with consumers' preferences.

Productive Efficiency

Productive efficiency is achieved when a market or firm produces goods at the lowest possible cost. It occurs when resources are used in such a way that it is impossible to produce more of one good without reducing the output of another.
In a perfectly competitive market, productive efficiency is obtained when firms operate at their minimum average total cost. This means that they are making the best use of their resources:

• Firms are optimizing their production process.
• No further cost reductions can be achieved without sacrificing production elsewhere.
• Goods are produced using the least amount of resources and waste.

If the market is at or below equilibrium where total surplus is maximized, then productive efficiency is likely being achieved. Any deviation, like producing beyond equilibrium, can lead to inefficiencies and higher costs.

Supply and Demand Equilibrium

In a perfectly competitive market, supply and demand equilibrium is the point where the quantity of goods supplied is equal to the quantity of goods demanded at a certain price level. This equilibrium ensures that all resources are fully utilized without any excess supply or unmet demand.
The key characteristics of equilibrium include:

• The market clears, meaning no goods are left unsold.
• All consumers willing to pay the equilibrium price will obtain the product.
• There are no incentives for price changes, as any deviation would cause surpluses or shortages.

When a market is not in equilibrium, adjustments are necessary. For instance, when the current quantity produced exceeds the market equilibrium quantity, reducing output aligns supply with demand, maximizing total surplus and restoring balance.

Marginal Cost and Marginal Benefit Analysis

Marginal cost (MC) and marginal benefit (MB) analysis is a fundamental concept used to determine the optimal level of production. Marginal cost refers to the cost of producing one additional unit of a good, while marginal benefit is the additional satisfaction or utility gained from consuming an extra unit.
A market reaches optimal production when:

• MC equals MB, ensuring resources are used efficiently.
• There is no overproduction or underutilization of resources.
• Any production where MC exceeds MB indicates inefficiency and wasted resources.

When faced with a situation where MC exceeds MB, reducing output means avoiding unnecessary costs and adjusting production to match consumer demand, steering the market back towards equilibrium.