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:

1. Maximum willingness to pay exceeds the minimum acceptable price.
2. MC > MB.
3. Total surplus is at a maximum.
4. The current quantity produced exceeds the market equilibrium quantity.

Short answer

1. Total output should be increased.
2. Total output should be decreased.
3. Total output should be kept the same.
4. Total output should be decreased.

Step-by-step solution

Step 1. Meaning of productive and allocative efficiency

Productive efficiency is achieved when a good or service is produced with low cost and minimum wastage.

Allocative efficiency is achieved when the good or service produced is sold to the buyers who value a good or service higher than the cost incurred to produce them.

Economic efficiency is achieved when the above two happen. This occurs when the demand and supply are equal, and the market is in equilibrium.

Step 2. Explanation for part (a)

The gray shaded area in the below diagram shows all the output quantities for which the maximum willingness to pay off consumers exceeds the minimum acceptable price of suppliers. These are the quantities below the equilibrium level quantity Q.

For example, Q’

Thus, the total output should be increased to maximize the total surplus and achieve allocative and productive efficiency.

Step 3. Explanation for part (b)

The marginal benefit and marginal cost curves are shown below. The marginal benefit curve acts as a demand curve, and the marginal cost curve acts as a supply curve. The intersection of the two curves gives point O, at which the total surplus is maximum, as shown below:

If MC > MB, it refers to all the quantities above the equilibrium level of output Q (marked by gray region). For example, Q’ > Q. Thus, the total output should be reduced to reach Q level and maximize surplus while achieving allocative and production efficiency.

Step 4. Explanation for part (c)

The diagram given below gives Q as the equilibrium output level:

If the total surplus is maximum, it means the output being produced is the equilibrium level of output. Thus, the output level should not be changed as there is allocative and productive efficiency at this level Q.

Step 5. Explanation for part (d)

Consider the diagram given below:

If the current quantity (Q’) exceeds the equilibrium quantity (Q), it means the cost to sellers exceeds the value to buyers (MC > MB). Thus, the output should be reduced to reach the Q level so that allocative and productive efficiency can be achieved by maximizing total surplus. Any quantity above or below the equilibrium quantity creates efficiency loss.