Lesson 2: Total Surplus and Deadweight Loss

Economists hailing the power of markets alludes to..

The ability of markets to provide outcomes that are the most efficient to all other ways of organizing the exchange of goods (Efficient markets maximize both Consumer Surplus and Producer Surplus)

As WTP increases…

Consumer Surplus Increases (low budget/WTP= harder time to make a deal (buy too low for price))

As cost decreases…

Producer Surplus increases (High cost= harder to make a trade (sell for too high price))

Total Surplus

Total net gain to consumers and producers from trading in a market; simply the sum of consumer and producer surpluses (sum of CS + PS triangles at market equilibrium price and quantity)

A market is efficient if..

once the market has produced its gains from trade, there’s no way to make some people better off without making other people worse off.

3 approaches to take to alter what the market has done (altering done by government or some other entity)

1. Reallocation of Consumption among Consumers

2. Reallocation of Sales among Sellers

3. Changes in Quantity Traded (Efficiency Losses- or Deadweight Losses)

Reallocation of Consumption among Consumers

Might try to increase total surplus by selling product to different consumers (ex. Buyer with lower WTP will get product (gains CS) while Buyer with higher WTP wont (loses CS) → Lost CS (loss > gain)); inefficient because it LOWERS the total surplus

• Ex.: Housing set aside for low-income buyers

Reallocation of Sales among Sellers

Might try to increase total surplus by altering who sells the product, taking sales away from sellers who would’ve sold the product in the market equilibrium and instead compelling those who wouldn’t sold the product in the market equilibrium to sell them (ex. Low-cost seller can’t sell product (loses PS) while high-cost seller can (gains PS) → lost PS (gain <loss); inefficient because it LOWERS the total surplus

• Ex. Tariffs

Changes in Quantity Traded (Efficiency Losses- or Deadweight Losses)

Might try to increase total surplus by compelling more or sell the product to be traded than the market equilibrium quantity

• Below = lowest WTP buyers and highest cost sellers lose CS/PS

• Above = n/a buyers and sellers lose CS/PS

Discovery of the 3 approaches of attempting to fix the Market

1. Once the market has reached equilibrium, there’s no other way to increase the gains from trade (approaches reduce total surplus and efficiency)

2. When demand reflects consumers’ full WTP and when supply reflects all costs, the market equilibrium quantity will automatically equal the allocatively efficient output level

3. There are no efficiency losses due to underproduction or overproduction

4. efficiency losses do happen when either demand doesn’t reflect consumers’ full WTP or supply doesn’t reflect all costs

A price above the equilibrium..

might increase producer surplus, but it would decrease consumer surplus by more

A price below the equilibrium…

might increase consumer surplus, but it would decrease producer surplus by more

The competitive equilibrium price..

maximizes total surplus

Underproduction

Any quantity lower than the equilibrium quantity; inefficient. Any point to the left of the equilibrium quantity shows a situation where there’s someone willing to buy a good or service more than its costs to produce. Buyers and sellers will gain if production increases

Overproduction

Any point to the right of the equilibrium quantity shows a situation where it costs more to produce a good or service than anyone is willing to pay for it. Buyers and sellers will gain if production decreases.

Deadweight loss

The decrease in total surplus that results from an inefficient underproduction or overproduction; measures the scale of the inefficiency; the area of the triangle formed by the demand curve and the supply curve from the quantity produced to the equilibrium quantity.

Obstacles to Efficiency

Obstacles that bring underproduction or overproduction (causes Market failure):

• Taxes & subsidies

• Externalities

• Public goods and common resources

• Monopoly

• High transaction costs

4 Important functions of an Efficient Market

1. Allocates consumption of the good to the potential buyers who most value it (highest WTP)

2. Allocates sales to the potential sellers who most value the right to sell the good (lowest cost)

3. Ensures that every consumer who makes a purchase values the good more than every seller who makes a sale → all transactions are mutually beneficial

4. Ensures that every potential buyer who doesn’t make a purchase values the good less than every seller who doesn’t make a sale → no mutually beneficial transactions are missed

Equity and Efficiency

2 economic goals in conflict sometimes (policies that promote one of these goals will decrease the other); core of most debates about taxation