Question

Use the ideas of consumer surplus and producer surplus to explain why economists say competitive markets are efficient. Why are below- or above-equilibrium levels of output inefficient, according to these two ideas?

Short answer

The competitive markets are efficient because the produced output level maximizes the consumer and producer surplus (total surplus).

Any point above and below the equilibrium output level reduces the amount of total surplus and thus is inefficient.

Step-by-step solution

Step 1. Meaning of consumer and producer surplus

Consumer surplus is the difference between the maximum price a consumer is willing to pay (based on his/her opportunity cost) and the actual market price he/she pays.

For example, if a consumer is willing to pay a maximum of $2 for good A, it means he/she can divert resources in buying this good up to a limit of $2 worth of other goods and resources. If the market price of the said good is $1, then the consumer surplus is $1 (=2-1).

Producer surplus is the difference between the market price of a good and the minimum price that a producer can accept to produce and sell that good.

For example, the production of a unit of good A costs $5. The producer will produce good A (and divert resources towards this production) if the lowest price he/she receives is $5 (break-even price). If the market price is $6, then the producer surplus is $1 (=$6-$5).

Step 2. Efficiency in the competitive markets

Consider the following diagram. The demand curve and supply curve intersect at point “e.” At this point, the willingness to pay matches the minimum acceptable price. The scarce resources are used to produce high-valued goods (allocative efficiency) using the best technology at the minimum cost possible (productive efficiency).

Thus, the larger number of buyers and sellers ensures a competitive market which results in an equilibrium output level that reflects the allocative and productive efficiency in the market. The total surplus (consumer surplus + producer surplus) given by the shaded region is maximum at this level.

At the equilibrium level, all the producers who can produce at a lower cost and buyers who value the good higher than the price are included, maximizing the total surplus.

Step 3. Inefficiency at below- or above- equilibrium output levels.

Let’s use the diagram given below to understand why only the equilibrium level is economically efficient:

At the Q1 level of output (<Q), the maximum willingness to pay consumers (demand curve) exceeds the minimum acceptable prices for sellers (supply curve). The benefit of producing an additional unit is more than the opportunity cost of resources used to produce that unit of a good. There is a possibility of utilizing this difference and increasing the producer surplus (total surplus) by increasing the output level.

Similarly, at the Q2 level, the minimum acceptable price for sellers exceeds the maximum willingness to pay off the consumers. The benefit of producing an additional unit is less than the opportunity cost of resources. Thus, to reduce the costs and maximize the consumer surplus (total surplus), the output should be decreased.

Thus, only at the Q level, where demand is equal to the supply, the total surplus is maximized. Any point above or below the equilibrium level creates differences in benefits and costs, leading to inefficiency in the market.