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Economics
Concept Version 7
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Thinking about Efficiency

An efficient market maximizes total consumer and producer surplus.

Learning Objective

  • Define economic efficiency.


Key Points

    • Economists assume that firms seek to maximize their profits - defined as the difference between total revenue and total cost - while consumers seek to maximize their utility - which is roughly defined as the total satisfaction gained from goods, services, or actions.
    • An efficient allocation of resources maximizes total consumer and producer surplus.
    • Because they produce efficient outcomes, the seemingly haphazard workings of the marketplace can promote the common good.
    • Efficiency is but one of many vying goals in an economic system, and different notions of efficiency may be complementary or may be at odds.

Terms

  • producer surplus

    The amount that producers benefit by selling at a market price that is higher than the lowest price at which they would be willing to sell.

  • consumer surplus

    The difference between the maximum price a consumer is willing to pay and the actual price they do pay.


Full Text

Every economic transaction has a buyer and a seller who will only participate is she is receiving at least a minimum benefit. These benefits are represented as consumer surplus and producer surplus, respectively. In , both types of surpluses are displayed graphically. An efficient market maximizes total consumer and producer surplus.

Consumer and Producer Surplus

Consumer and producer surplus are maximized at the market equilibrium - that is, where supply and demand intersect.

The market shown in is one without any distortions such as regulations, taxes, or an inability for buyers to meet sellers. It is subject to what Adam Smith described as the invisible hand: if the price is anything except the equilibrium price, market forces will eventually return the market price to equilibrium .

Not all markets are efficient. There are a number of reasons why a market may be inefficient. Perhaps most well known is inefficiency caused by government intervention. Governments can institute any number of policies that prevent markets from achieving the free market equilibrium price and quantity: taxes raise prices, quotas limit the quantity sold, and regulations affect the supply and demand curves. Market inefficiency can also be caused by things such as irrational market actors and barriers to transactions, such as an inability for buyers and sellers to find one another.

Economists often seek to maximize efficiency, but it is important to contextualize such aims. Efficiency is but one of many vying goals in an economic system, and different notions of efficiency may be complementary or may be at odds. Most commonly, efficiency is contrasted or paired with morality, particularly liberty, and justice. Some economic policies may be seen as increasing efficiency at a cost to other goals or values, though this is certainly not a universal tradeoff. For example, taxation will always cause some inefficiency in markets, but many individuals believe that the benefits of programs such as Social Security and public schooling are worth the loss in efficiency.

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