2.3.6 Allocative efficiency at the competitive market equilibrium Notes

Societal/community surplus maximised at equilibrium

Figure 1a above illustrates how the social (or community surplus) is maximized when the market operates at equilibrium. This is because:

1. The consumer and producer surplus are maximised at $P_e$, $Q_e$.
2. This is evidenced by the fact that area of the social surplus at equilibrium is the largest it can be (at that $P_e$ and $Q_e$).

Consider now the market price is $P_1$ instead of $P_e$ (Figure 1b):

1. At this point, producers are only wiling and able to supply a quantity $Q_1$.
2. Therefore, all the quantities from $Q_1$ to $Q_e$, which would have been produced if the market was operating at equilibrium ($P_e$, $Q_e$), are now not being produced.
3. Hence, society is losing out on the social surplus from $Q_1$ to $Q_e$ that it would have benefited from if the market produced at $Q_e$.
4. Resultantly, the area of the social surplus is now smaller than the social surplus when the market operates at equilibrium.
5. This shows how social surplus is maximised when the market operates at equilibrium.

The loss in the social surplus in Figure 1b is referred to as the welfare loss.

1. The welfare loss can be understood as the loss of societal benefit for not operating at the equilibrium price.
2. Since equilibrium ensures allocative efficiency, social surplus is maximized and no welfare loss exists at that point..

Allocative efficiency: marginal benefit equals marginal cost

Allocative efficiency

Allocative efficiency allocates scarce resources in a way that maximises the benefits that society gets from consuming them. This occurs in a market when:

1. The marginal benefits of consumers equal the marginal costs of producers.
2. Social surplus is maximised.

Marginal costs

The supply curve can be interpreted as the marginal cost curve (2.2.2), which indicates the additional unit cost:

1. Producing goods and services has a marginal cost that is increasing (2.2.1).
2. Firms are only willing and able to supply one more unit of a good if the price at which they produce the extra unit covers its marginal costs.
3. Resultantly, the supply curve can be interpreted as the marginal cost curve (2.2.2), which indicates the additional cost of producing one extra unit of output.

Marginal benefits

The demand curve can be interpreted as the marginal benefit curve (2.1.2), which indicates the additional unit benefit:

1. Consuming goods and services provides a marginal benefit (2.1.1) that decreases as more units are consumed.
2. Consumers are only willing and able to purchase one more unit of a good if the price they pay matches the marginal benefit they derive from consuming that additional unit.
3. Consequently, the demand curve can be interpreted as the marginal benefit curve (2.1.2), representing the additional benefit gained from consuming one extra unit of a good.

Allocative efficiency when MB = MC

If the supply curve is thought of as marginal cost $MC$, and demand curve as marginal benefit $MB$, then the equilibrium takes place when $MC=MB$ (Figure 2).

Figure 2 above illustrates how allocative efficiency is achieved only when $MC=MB$: At the intersection of $MC$ and $MB$:

1. The benefit from the consumption of the last unit is equal to the cost of producing the last unit.
2. The additional benefit and additional cost of a unit are balanced and society is allocating the resources efficiently for that good (consumers and producers agree of the amount and quantity that should be produced).

For allocative efficiency to be achieved, the market must have $MB = MC$, and if all markets have $MB = MC$ then the entire economy achieves allocative efficiency.