4 Economic Efficiency
Introduction
A major question of interest for economists is whether our current economic, social and political arrangements are efficient. In this chapter, we explore the idea that markets are allocatively efficient, and that government intervention leads to inefficient allocation of resources. This argument is often made by right leaning politicians. That you tend to agree with these politicians or not, it is essential to understand their arguments. In order to be able to make these arguments, we will start by introducing the concept of producer surplus and consumer surplus. We will then define concepts of efficiency: Pareto Efficiency and Kaldor-Hicks Improvements. Once we define these concepts, we introduce the concept of total economic surplus and how central it is to the analysis of policies. Finally, we look at different government policies: price floor and price ceiling. We will argue that they decrease total welfare.
Profit, Cost and Producer Surplus
As stated in chapter 2, the cost of producing an extra good is given by the supply curve, as seen in the following graph:
The area under the supply curve up to the quantity produced ([latex]Q_S[/latex]) is the cost of producing these units:
The revenue generated by the firm is Price[latex]\times[/latex]Quantity. This is the blue area on the graph (notice that the height of the box is the price, and the length is the quantity, the area represented by the box is indeed Price[latex]\times[/latex]Quantity):
The producer surplus is the revenues generated by the firm minus the cost of producing the goods: it is the profit of the firm. We can find the producer surplus (profit) graphically (The blue area minus the red area):
Notice that the producer surplus is a triangle. Remember that the area of a triangle can be calculated as:
Area of a triangle[latex]=\frac{Height\times Base}{2}[/latex]
Example 4.1
Question: The supply curve is given by: [latex]P=100+\frac{1}{2}Q_s[/latex] and the price is $300. Calculate the producer surplus (PS). Here is a graphical representation:
Answer:
Step 1: Calculate how many units the firm will supply at a price of $300:
[latex]300=100+\frac{1}{2}Q_s[/latex]
[latex]300-100=\frac{1}{2}Q_s[/latex]
[latex]2\times200=2\times\frac{1}{2}Q_s[/latex]
[latex]400=Q_s[/latex]
At a price of $300, the firm wants to supply 400 units.
The 400 units is the base of the triangle. The height of the triangle, which is the vertical length of the triangle, is 200 (the highest point of the triangle is 300, but the triangle starts at 100, so the vertical length is [latex]300-100=200[/latex]).
The profit is: [latex]\frac{400\times200}{2}=$40,000[/latex]
Consumer Surplus
The consumer surplus is the surplus, benefit or gains from trade that consumers get from consuming a good or a service. When you go to the store, and you buy a product, what do you get out of it? Obviously, you get the product but often you get more than the product: you pay less than your willingness to pay (WTP). The difference between how much you are willing to pay and the price is the Consumer Surplus.
Example 4.2
Consider the following demand curve for Guillermo’s demand for bicycles:
Guillermo has a WTP of $700 for his first bicycle and the price of a bicycle is $300. In a sense, Guillermo receive a surplus of $400 because he pays less than what he is willing to pay for the bicycle. He would have been willing to buy the same bicycle if it was priced at $500, $650 or $700. Because the price was only $300, he will be able to spend the $400 that he didn’t spend on the bicycle on other goods. Guillermo is made better off by $400!
Students tend to find the concept of consumer surplus more confusing than the concept of profit or producer surplus. The producer surplus is easy to grasp, because firms routinely make and report their profit. Consumers don’t often report their consumer surplus. If a consumer buys a slice of pizza for $5, it means that this slice of pizza is worth at least $5 for them. If the slice of pizza was worth $4 for them, they would effectively lose $1 by buying the slice of pizza. As such, whenever consumers buy a product, they must value it more than the price they pay for it. The difference between their WTP and the price paid is implicitly a discount that they received on the purchase.
We can also view the consumer surplus graphically. The area under the demand curve up to the quantity consumed is the gross benefit that consumers get:
The cost that consumers have to pay for these units is the number of units bought multiplied by the price. This area is represented graphically in the following graph (Notice, that this is equal to the revenue that the firm receives. See the section on the producer surplus above.):
The consumer surplus is simply the net benefit that consumers get from consumption: The gross benefit minus the cost. You can see the consumer surplus graphically in the following graph:
