Efficiency of Markets
Welfare economics is the study of how the allocation of scarce resources affects the well-being of every participant in a given economy and efficiency of markets. As such, welfare economics is a normative idea rather than a positive one. Keep in mind that free markets allocate goods in a desirable way, since they maximize total surplus (consumer surplus + producer surplus). Consider that:
- Consumer Surplus = Value to buyers - amount paid by buyers
- Producer Surplus = Amount received by producers - cost to sellers
- Total Surplus = Value to buyers - amount paid by buyers + amount received by sellers - cost to sellers
- But since amount paid and received are the same, Total Surplus = Value to buyers - Cost to sellers
An allocation that maximizes surplus is said to be efficient. Unfortunately, an efficient system does not necessarily correspond to a fair one. Whether or not free market allocations are fair is known as division of equity.
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Consumer and Producer Surplus
The difference between how much the consumer values the good (their maximum price) and how much the consumer ends up paying, is known as the consumer surplus. Graphically, consumer surplus is the area under the demand curve but above the price. It represents the net benefit received by purchasers as the purchasers themselves perceive it. This surplus is a good measure of economic well-being if we respect the choices of the buyers.
Cost is the value of everything that the producer must give up in order to produce the good. The supply curve shows the cost of producing additional units, and hence the minimum price that the producer should and will accept. The difference between the cost and the amount received is known as the producer surplus, which is sometimes referred to as profit. It is the amount the buyer pays the seller, minus the seller's cost of production. Graphically, it is the area above the supply curve and under the price.
Free Markets and Equilibrium
A free market in equilibrium will:
- Allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay.
- Allocate the demand for goods to the sellers who can produce them at least cost.
- Produce the quantity of goods that maximizes the total surplus.
If there is competition in the market but no significant externalities (or outside effects) of a transaction, the free market result is efficient and benefits both the producer and the buyer. It may or may not be fair since it depends on the existing distribution of income and wealth.
Note that it does take time for a free market to reach equilibrium (especially markets with new businesses), and projected equilibrium prices and quantities can change due to externalities.