Economic efficiency

Posted 2023-02-27 16:37:09

Key Points

Economic efficiency is the idea that it is impossible to improve the situation of one party without imposing a cost on another.
If a situation is economically inefficient, it becomes possible to benefit at least one party without imposing costs on others.
Consumer surplus is the gap between the price that consumers are willing to pay—based on their preferences—and the market equilibrium price.
Producer surplus is the gap between the price for which producers are willing to sell a product—based on their costs—and the market equilibrium price.
Social surplus is the sum of consumer surplus and producer surplus. Total surplus is larger at the equilibrium quantity and price than it will be at any other quantity and price.
Deadweight loss is loss in total surplus that occurs when the economy produces at an inefficient quantity.

Introduction

Did you know that demand and supply diagrams can help us understand more than supply and demand curves and equilibrium? They can also help us understand economic efficiency!

Efficiency is one of those words you might hear in day-to-day conversation, but it means something a little different to economists. In economics, efficiency means it is impossible to improve the situation of one party without imposing a cost on another. Conversely, if a situation is inefficient, it becomes possible to benefit at least one party without imposing costs on others.

The meaning of efficiency can become even more specific than that, though! In the demand and supply model, efficiency means that the economy is getting as much benefit as possible from its scarce resources and all possible gains from trade have been achieved. In other words, the optimal amount of each good and service is being produced and consumed.

Consumer surplus, producer surplus, and social surplus

The idea of economic efficiency and inefficiency can feel a little abstract. Let's dig deeper into some case studies to understand these concepts better.

Consider a market for tablet computers. The equilibrium price is $80 and the equilibrium quantity is 28 million—shown in the demand and supply diagram below. The segment of the demand curve above the equilibrium point and to the left represents the benefit to consumers. It shows that at least some demanders would have been willing to pay more than $80 for a tablet.

For example, point start text, J, end text shows that if the price were $90, 20 million tablets would have been sold. Consumers who would have been willing to pay $90 for a tablet but who were able to pay the equilibrium price of $80 clearly received a benefit—they received the same utility they were willing to pay $90 for at a reduced price.

Remember, the demand curve traces consumers’ willingness to pay for different quantities. The amount that individuals would have been willing to pay minus the amount that they actually paid, is called consumer surplus. We can understand this concept graphically as well; consumer surplus is represented by the area labeled start text, F, end text in the diagram below—the area above the market price and below the demand curve.

The supply curve shows the quantity that firms are willing to supply at each price. For example, point start text, K, end text in the diagram above illustrates that if tablet computers cost $45, firms still would have been willing to supply a quantity of 14 million. Those producers who would have been willing to supply the tablets at $45 but who were instead able to charge the equilibrium price of $80 received an extra benefit beyond what they required to supply the product.

The amount that a seller is paid for a good minus the seller’s actual cost is called producer surplus. Graphically, this surplus is represented by the area labeled start text, G, end text in the diagram above—the area between the market price and the segment of the supply curve below the equilibrium.

The sum of consumer surplus and producer surplus is social surplus, also referred to as economic surplus. In our diagram, social surplus is the area start text, F, end text, plus, start text, G, end text. Social surplus is larger at equilibrium quantity and price than it would be at any other quantity.

Think back now to the definition of economic efficiency—it is impossible to improve the situation of one party without imposing a cost on another.

At the efficient level of output, it is impossible to produce greater consumer surplus without reducing producer surplus, and it is impossible to produce greater producer surplus without reducing consumer surplus. This efficient level is the market equilibrium!

Price floors and price ceilings are inefficient

So, if equilibrium is economically efficient, under what circumstances can we find economic inefficiency? A price floor or a price ceiling will prevent a market from adjusting to its equilibrium price and quantity, thus creating an inefficient outcome. But there's an additional twist! In addition to creating inefficiency, price floors and ceilings also transfer some consumer surplus to producers or some producer surplus to consumers.

Imagine that several firms develop a promising but expensive new drug for treating back pain. If this therapy were left to the market, the equilibrium price would be $600 per month and 20,000 people would use the drug, as you can see in our demand and supply model A, on the left below. In this situation, the level of consumer surplus would be start text, T, end text, plus, start text, U, end text and producer surplus would be start text, V, end text, plus, start text, W, end text, plus, start text, X, end text.

Now, let's imagine that the government imposes a price ceiling of $400 to make the drug more affordable. We know based on model A below that at this price ceiling, firms in the market would only produce 15,000. As a result, two changes would occur.

First, we would get an inefficient outcome and the total social surplus would be reduced. The loss in social surplus that occurs when the economy produces at an inefficient quantity is called deadweight loss. In a very real sense, it is like money thrown away that benefits no one. In model A below, the deadweight loss is the area start text, U, end text, plus, start text, W, end text. When deadweight loss exists, it is possible for both consumer and producer surplus to be higher than they currently are, in this case because a price control is blocking some suppliers and demanders from transactions they would both be willing to make.

A second change from the price ceiling is that some of the producer surplus is transferred to consumers. After the price ceiling is imposed, the new consumer surplus is start text, T, end text, plus, start text, V, end text, while the new producer surplus is start text, X, end text. In other words, the price ceiling transfers the area of surplus—start text, V, end text—from producers to consumers. Note that the gain to consumers is less than the loss to producers, which is just another way of seeing the deadweight loss.

Now let's look at how price floors affect efficiency. Demand and supply model B, on the right above, represents a string of struggling movie theaters, all in the same city. The current equilibrium is $8 per movie ticket, with 1,800 people attending movies. The original consumer surplus is start text, G, end text, plus, start text, H, end text, plus, start text, J, end text, and producer surplus is start text, I, end text, plus, start text, K, end text.

The city government is worried that movie theaters will go out of business, reducing the entertainment options available to citizens, so it decides to impose a price floor of $12 per ticket. As a result, the quantity demanded of movie tickets falls to 1,400. The new consumer surplus is start text, G, end text, and the new producer surplus is start text, H, end text, plus, start text, I, end text. In effect, the price floor causes the area start text, H, end text to be transferred from consumer to producer surplus, but it also causes a deadweight loss of start text, J, end text, plus, start text, K, end text.

So, price ceilings transfer some producer surplus to consumers—which helps to explain why consumers often favor them. Conversely, price floors transfer some consumer surplus to producers, which explains why producers often favor them.

However, both price floors and price ceilings block some transactions that buyers and sellers would have been willing to make, creating deadweight loss. Removing such barriers, so that prices and quantities can adjust to their equilibrium level, increases the economy’s social surplus.

Summary

Economic efficiency is the idea that it is impossible to improve the situation of one party without imposing a cost on another.
If a situation is economically inefficient, it becomes possible to benefit at least one party without imposing costs on others.
Consumer surplus is the gap between the price that consumers are willing to pay—based on their preferences—and the market equilibrium price.
Producer surplus is the gap between the price for which producers are willing to sell a product—based on their costs—and the market equilibrium price.
Social surplus is the sum of consumer surplus and producer surplus. Total surplus is larger at the equilibrium quantity and price than it will be at any other quantity and price.
Deadweight loss is loss in total surplus that occurs when the economy produces at an inefficient quantity.