Econ- market efficiency

Efficiency in economics

defined as maximizing economic welfare. It means producing goods that society wants at the lowest possible cost - making the best use of scare resources. Involves maximizing net benefits as measured by total surplus.

Efficient and inefficient outcomes

efficient- not possible to make someone better off without making someone worse off. inefficient- possible to improve total wellbeing in society by reallocating resources.

Importance of efficiency

resources are scarce and they need to be used in the best possible way rather than being wasted on producing things that society does not necessarily value.

Consumer Surplus

is the difference between what a consumer is prepared to pay and what they actually pay in the market. is the difference between total benefits and expenditure.

It represents the extra benefit or value consumers receive from purchasing a good at the market price.

Total benefits

represented by the area under the demand curve up to the quantity consumed. represents the total willingness to pay for a good.

Total expenditure

price × quantity (what consumers actually pay)

Rise in consumer surplus

Consumers' welfare has increased as consumers will be able to buy more at a lower price.

Measure of consumer welfare

changes in consumer surplus is a better measure of economic welfare than changes in consumer expenditure

Demand curve

willingness to pay curve

Producer Surplus

is the difference between what a producer is willing to receive (minimum supply price or cost of production) and what they actually receive in the market. the difference between total revenue and cost.

It represents the extra earnings producers receive for selling at the market price.

Total revenue

Price × Quantity (rectangle under the price line)

Total costs/ total variable costs

Area under the supply curve

What causes a rise in producer surplus

If the market price rises there will be an increase in producer surplus because producers will sell more at a higher price.

What does a rise in producer surplus indicate

Firstly that the market price has risen, and secondly that the producer is better off as in their economic welfare has increased.

Total surplus

a measure of the net benefits to society from the production and consumption of a good. It represents the overall gain in welfare to both consumers and producers, after accounting for the cost of using scarce resources.

Total surplus = Consumer surplus + Producer surplus (adds up the welfare gained by both sides of the market.)

Total surplus = Total benefits - Total costs (reflects the net value society gets from producing and consuming the good)

total surplus and economic efficiency

economic efficiency occurs when total surplus is maximized. meaning the allocation of resources results in the highest possible net benefits to society.

Happens only at the market equilibrium (where demand = supply), because:

• All mutually beneficial trades happen.

• No resources are wasted.

• No one can be made better off without making someone else worse off.

Deadweight loss

• happens when total surplus falls due to underproduction or overproduction.

• It is an avoidable loss of surplus caused by something making the market not produce the optimal output.

• A shift in equilibrium is not a deadweight loss — the new equilibrium is still efficient and total surplus will still be maximized, even if society is worse off.

Example of deadweight loss

• Underproduction example: Firms restrict output to raise prices (using market power).

• Overproduction example: Pollution imposes external costs on society, decreases society's total surplus or economic well-being, i.e. a deadweight loss.

Government role in deadweight loss

Adress weaknesses in market economy to fix market failures and reduce deadweight loss.

BUT government policies that intervene in the market by introducing policies that reduce market efficiency can also cause DWL by leading to over- or underproduction.

Tax

• used to raise revenue for the government for spending on society, so it is arguably beneficial to improve our economic welfare.

• It artificially raises price which is either passed on to the consumer or producer or both (tax incidence)

• Must minimalize deadweight loss

Types of goods to put tax on (elastic/inelastic)

• Placing tax on inelastic goods will result in a small change in quantity demanded so the deadweight loss will be small.

• Placing tax on elastic goods will result in a large change in quantity demanded so the deadweight loss will be large.

Impact of taxes

causes market price to increase, quantity to fall.

• CS decrease- consumers pay more and buy less.

• PS decrease- producers receive less and sell a lower quantity.

• tax raises revenue for the government- when it’s spent it will offset some of the decrease in total surplus. But the tax revenue is less than the loss in total surplus, so the tax will always create a deadweight loss because output in the market has decreased (fewer goods and services are being bought with the tax than before where there was no tax). Thus, taxes are inefficient.

Subsidy

• payment made to a producer to help them reduce costs of production and increase output, e.g. in the Australian motor industry (paying up to $50k for every person employed)

• It benefits consumers because it reduces the price and it benefits producers because it reduces costs.

Impact of subsidy

causes market price to decrease, quantity to increase

• CS increases because customers are paying less and buying more

• PS increases because producers are earning more and selling more

• BUT there is opportunity cost because it comes out of government spending

• cost of subsidy is greater than the combined increase in CS and PS so this subsidy will always create a deadweight loss- a decrease in total economic surplus. So subsidies are economically inefficient.

Price ceiling

• legislated maximum price set below the equilibrium price. Usually a government policy put in place to increase equality, i.e. to try and make things more affordable for everyone.

• It fails because it artificially reduces price which therefore reduces supply, causing a surplus where the quantity supplied is less than the quantity demanded.

Impact of price ceiling

• it may increase consumer surplus, but at the same time many people are worse off because they can’t buy the good due to the shortage.

• Producer surplus decreases by more than CS increases since producers receive less and sell lower quantities. Total surplus falls because mutually beneficial trades at equilibrium are lost, and this reduction is the deadweight loss.

• can create black markets for a good

• Effects on equity: the price ceiling will reduce the price of essential items (such as food or housing) which will improve equity, however, there is now a shortage and some consumers may get less of the essential item, which has a negative effect on equity

• Effects on market efficiency: the price ceiling reduces market efficiency because it causes a deadweight loss (DWL) – a decrease in total surplus.

Price floor

• legislated minimum price that suppliers are allowed to charge in the market.

• purpose is justified on equity grounds to help low income producers - raise income/ stabilize prices.

• It fails because it results in the market failing to produce the optimal quantity and it is therefore inefficient. Producers are happy but consumers are not as they are paying more and getting less.

Impact of price floor

• CS decrease because consumers pay more and get less

• PS normally increases if total revenue increases (depending on elasticity of demand).

• For elastic goods, total revenue will fall (higher price per unit can’t offset big fall in quantity) so producer surplus will decrease. For inelastic goods, total revenue may increase (higher price per unit CAN offset small fall in quantity), so producer surplus will increase. All because producer surplus= total revenue-costs, so bigger TR means bigger PS.

Causes market inefficiency because CS falls more than PS increases, creating deadweight loss - a fall in total surplus