Efficient Markets

Total welfare in a market is the sum of the welfare of consumers

(consumer surplus) and the welfare of producers (producer
surplus).

$4

3
D
8 10

Consumer surplus comes from the notion that demand curves

represent maximum prices that consumers are willing & able
to purchase specific quantities of goods & services.
For example, consumers may be willing, at most, to pay $4
per unit for 8 units of the above product (thus spending $32),
but they would of course prefer to pay less per unit (e.g.,
spending $24 on 8 units at $3 per unit).

efficient markets

Here, the consumer is willing to pay no more than $5 for 6 units.

The $30 then represents the maximum they would pay when
purchasing 6 units all at once. The area defined in the above
rectangle equals $30, or $5 times 6 units.

P
6
$5

$30
D
6

If the consumer in this example was offered to

purchase at $6 per unit, the consumer would not
choose 6 units. Rather, they would choose the
quantity that coincided with $6 per unit on their
demand curve; less than 6 units.

efficient markets

In effect, each maximum price could be extracted from the consumer for each added quantity by
walking the consumer down their demand curve. This activity is surely not preferred by the
consumer, but consumers are willing to play-along in the sense that they are not being asked to pay
more than their maximum price for each added quantity. Consumers are just not receiving any
break or surplus value in the sense that they pay less than their maximum price for any quantity.
Consumer surplus considers the difference between what consumers actually pay and what their
maximum payment would be. This difference is a surplus because it reflects a gain in welfare for
the consumer. If Mary is willing to pay $3 for another bagel but only pays $2 her surplus is $1.
Since total expenditure equals price times quantity, the area under the demand curve up to the total
quantity purchased equals total expenditures extracted when maximum prices are charged.

In theory, the entire area under the demand

curve represents the maximum revenues or
expenditures that may be collected.

D
Q

In practice, however, sellers rarely have the ability to price each added quantity at a different
(maximum) price.
So, the next step is to contrast the above case with the more common case whereby only one price
per unit is charged.
efficient markets

Consumer Surplus is defined as the difference between what consumers are at most willing to
pay and what they actually pay for goods and services. Lets evaluate consumer surplus at
quantity d.

CS

a
what
they
pay
0

Area 0bcd is the maximum expenditure & area 0acd

is the actual payment when only one price per unit
is charged. Consumer surplus then is area abc, the
difference in these two expenditures.

efficient markets

Consumer Surplus rises (falls) as price falls (rises) thus demonstrating that consumers
are better-off (higher welfare) with lower prices.

P
P

CS

CS

P
what
they
pay

P
what they pay

D
Q

efficient markets

D
Q

Consumer Surplus Rises with a Price Fall

Consumer surplus at (P1,Q1) is area A

Consumer surplus at (P2,Q2) is A+B+E
The rise in consumer surplus from a lower price is B+E here.
The gain in consumer welfare is therefore measured in dollars.

A
P1

P2

C
Q1

D
Q2
efficient markets

P
$5

Supply represents minimum prices producers are

willing to accept for various quantities.
Here, sellers are willing to receive $3 per unit for 8
units ($24 total revenue) and $5 per unit for 10 units
($50 total revenue).

3
8

10 Q

Of course, they would prefer to receive more than $3

per unit for 8 units; e.g., $4, but they are willing to
receive $3 at a minimum payment per unit for 8 units.

efficient markets

In effect, producers could charge each minimum price for each possible quantity by walking up
the supply curve.
The area under the supply curve then represents the minimum payment sellers are willing to take.

efficient markets

Producer Surplus is defined as the difference

between what producers receive and the
minimum payments they would have been
willing to receive.

P
S
$5

Area B represents the minimum payment for 6

units.

However, when they receive $5 per unit, they

receive A+B (=$30).

B
6

Producer surplus then is A, the difference between what they receive (A+B) and the
minimum they would take (B).

efficient markets

Producer surplus rises with price as demonstrated below.

CS
P

CS

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10

Total Surplus at Market Equilibrium

In market equilibrium, the consumer surplus (PAE) and producer surplus (CPE) are shown below.
Total surplus or welfare is the sum of these two surpluses & equals area CAE.
Notice equilibrium occurs where we
have the largest quantity & lowest
P
price where both buyers & sellers
can reach agreement. Equilibrium
A
price is where the lowest price
producers are willing to take just
equals the maximum price
consumers are willing to pay.

Consumer
surplus

Pe
Producer
surplus

Notice that equilibrium occurs

where total surplus is maximized,
thus demonstrating that private
markets maximize welfare of both
buyers & sellers when allowed to set
prices & quantities.

C
0

Qe

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11

Multiple Choice
1. Which of the following best explains the source of consumer surplus for good A?
a. Many consumers would be willing to pay more than the market price for good A.
b. Many consumers pay prices that are greater than the equilibrium price of good A.
c. Many consumers think the market price of good A is greater than its cost.
d. Many consumers think the price elasticity of demand for good A is unit elastic.
2. Suppose a market now has a large increase in the number of sellers of groceries, ceteris paribus. Which of the
following would you predict would also arise following the change in market price?
a. consumer surplus will remain the same.
b. consumer surplus will increase.
c. it is not possible to predict the change in consumer surplus.
d. consumer surplus will decrease
3. Suppose a market now has a large increase in the number of demanders of groceries, ceteris paribus. Which of the
following would you predict would also arise following the change in market price?
a. producer surplus will remain the same.
b. producer surplus will increase.
c. it is not possible to predict the change in producer surplus.
d. producer surplus will decrease
4. Suppose that in the wine market, consumer surplus equals $500 and producer surplus equals $400. Which of the
following is correct?
a. total surplus equals $100
b. total surplus equals $20,000
c. total surplus equals $500
d. total surplus equals $900
5. Suppose that in the wine market, consumer surplus equals $5,000 and producer surplus equals $3,000. Suppose
that in the beer market, consumer surplus equals $1,000 and producer surplus equals $8,000. Which of the following
is correct?
a. total surplus is highest in the wine market
b. total surplus is highest in the beer market
c. total surplus is equal in the two markets
d. we cannot cross-compare in the two markets.
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12

What are Price Ceilings & Price Floors?

Markets set prices by the interactions of consumers (demand) & suppliers (supply).
Price ceilings and floors dictate various limits on which prices are allowed to be charged.
Pc is an example of a price ceiling dictated by government. Here price may go no higher than Pc
(hence the word ceiling), although the private market would set the equilibrium price at Pe.

A price ceiling is generally rationalized by

the belief that the private market would set
the price too high and therefore a price
ceiling is warranted to protect consumers.

Pe
Pc
D
Qe
efficient markets

Q
13

Pf is an example of a price floor dictated by government.

Here price may go no lower than Pf (hence the word floor), although the market would set the
equilibrium price at Pe.
A price floor is generally rationalized by the belief that the private market would set the price too
low and therefore a price ceiling is warranted to protect sellers.

Pf
Pe

Qe
efficient markets

Q
14

Shortages are Symptoms of Price Ceilings & Surpluses are Symptoms of Price Floors.

Private markets eliminate shortages and

surpluses through their ability to raise or
lower prices.

Surpluses and shortages therefore are

absent whenever private markets are
allowed to set prices at equilibrium levels.

Pe

D
Q
Qe=Qs=Qd

no shortages or surpluses possible when price

is set at equilibrium Pe.
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15

A price ceiling such as Pc mandates that prices may go no higher than Pc.
But, at Pc, quantity demanded exceeds quantity supply, and thus a shortage arises.
In other words, a law mandating a price
ceiling is a law that indirectly mandates a
shortage.
Notice the shortage grows as the price
ceiling is set farther away from Pe.

Pe

At Pc, quantity demanded of Q2 arises and

quantity supplied of Q1 arises, thus
generating a shortage equal to distance
Q1Q2.

Pc

D
Q1

Q2

shortage

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16

A price floor such as Pf is a law mandating that prices may go no lower than Pf.
But, at Pf, quantity supplied exceeds quantity demanded, and thus a surplus arises.

In other words, a law mandating a price floor

is a law (indirectly) mandating a surplus.

Notice that the surplus grows as the price floor Pf

is set farther away from Pe.
At Pf, quantity demanded of Q1 arises and
Pe
quantity supplied of Q2 arises, thus generating
a surplus equal to distance Q1Q2.

D
Q1

Q2

surplus

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17

Distinguish Between Costs & Benefits of Price Ceilings

and Price Floors.
Economists list costs and benefits of policies as a method
by which to appraise the desirability of public policies.
The greater that benefits outweigh costs, the more
desirable public policies are.
Benefits of price ceilings and floors are fairly obvious.
A price ceiling imposed on gasoline of $1 per gallon,
when the equilibrium price is $2, allows consumers to
purchase the product at half of equilibrium price.
A price floor of $2 per orange, when the equilibrium
price is $1, allows sellers to receive double the
equilibrium price.

$10
5
D
Q1

Q2

Costs are more difficult to assess and require a command of supply and demand analysis.
Consider a price ceiling of $5 per pizza, when equilibrium is $10 (see nearby graph).
The price ceiling creates a shortage of distance Q1Q2 because quantity demanded Q2 exceeds
quantity supplied Q1.
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18

This is a cost because a shortage means that not all

consumers may purchase as many pizzas as they want
(= Q2).
They may purchase only the quantity supplied of Q1.
So some consumers will be unsatisfied.
Another cost is that product quality will tend to
diminish; e.g., pizzas may be become smaller or
otherwise of lower quality.
Sellers may also start charging for boxes or delivery,
thus in effect raising prices.

$10
5

D
Q1

Q2

The price ceiling may also cause sellers to choose who receives available pizzas, and who do not, on
the basis of race, gender, or some other characteristic.
Sellers may also choose to provide on the basis who pays the highest bribes.
The point here is that sellers must decide on some basis who receives available pizzas.
This issue, however, does not come up when prices are allowed to equilibrate because a shortage
never arises at the equilibrium price.
efficient markets

19

A long-standing price ceiling is also likely to foster an exodus out of the market by suppliers.
Suppliers do not like to have their hands tied
behind their backs by price ceilings and, over
time, suppliers will leave this market for markets
without price ceilings.
Suppliers leaving this market causes the supply
curve to shift left from S to S.
Notice, that as the supply curve shifts leftward,
the shortage grows to distance Q3Q2.

$11
$10
5

D
Q3 Q1

Q2

Also, the price will jump to $11, a price above the initial equilibrium of $10, when the price
ceiling is lifted. (However, over time the price will eventually fall back to $10 if no other changes in
the market have taken place).
The point here is that shortages will tend to grow over time and (in the short run) equilibrium prices
will rise over time, as long as price ceilings remain in place.
How Goods & Services are Rationed When Prices are not Allowed to Reach Equilibrium. This was
explained above in reference to how sellers must determine who receives the available pizzas and who
do not when the price ceiling results in a shortage. Sellers may decide to allocate available pizzas
based on eye colors of consumers, or national origin, gender, zip code or hair color. They could also
choose randomly or on the basis of which consumers offer the best bribes.
efficient markets

20

A minimum wage law is a price floor because it mandates that employers must pay workers at least
the defined minimum. The nearby chart shows a minimum wage at $7 per hour, although the
private market sets $5 as equilibrium wage.
A minimum wage of $7 per hour creates unemployment
because it causes a surplus of labor.
At $7 per hour, quantity demanded (by employers) of labor
is Q1, quantity supplied (by workers) is Q2, and thus
distance Q1Q2 is the surplus, or unemployment.

wage

Unemployment created by a minimum wage law can be broken

down into 2 components.

$7

$5

1. Q1A = workers who used to work, but no longer do. A =

workers hired at equilibrium price $5, and some of them lose
their jobs because employers cut back on hiring by walking
up their demand for labor curve to $7.
2. AQ2 = workers who did not previously want to work at $5, but
now want to work at $7. This movement is shown by going
upward along the supply of labor curve. The minimum wage
entices these workers to want to work, but unfortunately they are
unable to find work because, at $7, employers only hire Q1
workers.
efficient markets

Q1

Q2

workers

Unemployment
(surplus)

21

Workers, Consumers and Owners Bear the Economic Incidence of Minimum Wage Laws. Minimum
wage laws create unemployment and have the potential for raising prices and output levels. These
effects carry the potential for passing on costs of minimum wage laws to different parties. A minimum
wage law raises the costs of production to sellers and thus causes the supply curve to shift left, as
shown in the nearby chart.

While workers who remain employed receive

higher wages (benefit from law), there are also
costs to the policy. There are 4 potential groups
of losers.
1. Workers lose when output falls (from Q to
Q) and therefore fewer workers are needed.
2. Consumers lose because they now pay
higher prices (from P to P).

S (under min. wage)

S (initial)

P
P
D

3. Businesses lose because their costs of

production go up thus lowering profits.
4. Governments lose when tax revenues drop if
firms sell less and/or go out of business.

efficient markets

Q Q

milk shakes

22

6. Suppose a minimum wage is set a level above the equilibrium wage. Which of the following describes the
unemployment created associated with movement along the demand curve for labor?
a. workers who used to work, but are laid off
b. individuals who did not previously seek work, but now do at the higher wage
c. none of the above
d. all of the above
7. Suppose a minimum wage is set a level above the equilibrium wage. Which of the following describes the
unemployment created associated with movement along the supply curve of labor?
a. workers who used to work, but no longer can find employment
b. individuals who did not previously seek work, but now do at the higher wage
c. none of the above
d. all of the above
8. Suppose a price ceiling is set above equilibrium price in the apple market. Which best describes what will
happen?
a. a shortage will develop
b. a surplus will develop
c. the market will stay at equilibrium
d. both a shortage and a surplus will develop
9. Suppose a price ceiling is set below the equilibrium price in the apple market. Which of the following best
describes what will happen?
a. a shortage will develop
b. a surplus will develop
c. the market will stay at equilibrium
d. both a shortage and a surplus will develop
10. Increases in both the supply and demand for caviar will:
(a) affect price in an indeterminate way and increase the quantity exchanged.
(b) increase price and increase the quantity exchanged.
(c) affect quantity in an indeterminate way while reducing the price.
(d) decrease price and decrease the quantity exchanged.
(e) affect price in an indeterminate way and decrease the quantity exchanged.
efficient markets

23

Use the table to answer the following 4 questions.

Each question is self-contained (i.e., only use
information provided in each question).

PRICE
$10
9
8
7
6
5
4

QU.
SUPPLIED
600 units
500
400
300
200
100
0

QU.
DEMANDED
50 units
100
200
300
400
700
900

11. Suppose a price ceiling is set where price may not go any higher than $8 per unit. Which of the following is true?
a. There will be a shortage of 200 units
b. There will be a surplus of 200 units
c. There will be shortage of 600 units
d. There will be no shortage or surplus
12. Suppose a price floor is set where price may not go any lower than $8 per unit. Which of the following is true?
a. There will be a shortage of 200 units
b. There will be shortage of 600 units
c. There will be a surplus of 200 units
d. There will be a surplus of 600 units e. There will no shortage or surplus
13. Suppose a price ceiling is set where price may not go any higher than $7 per unit. Which of the following is true?
a. There will be a shortage of 200 units
b. There will be shortage of 600 units
c. There will be a surplus of 200 units
d. There will be a surplus of 600 units e. There will no shortage or surplus
14. Suppose new suppliers enter this market and provide at each price an additional 200 units; e.g., at price $10,
quantity supplied becomes 800 units, at price $9 quantity supplied becomes 700 units, etc. Which is true?
a. There will be a shortage of 600 units if there is a price ceiling set at $5
b. There will be shortage of 200 units if there is a price ceiling set at $6
c. There will be a surplus of 200 units if there is price ceiling set at $9
d. There will be no shortage or surplus at a price of $6
e. none of these is true
24
efficient markets

15. Use the graph on the right for the following question. If price falls
from Pa to Pb, which of the following is correct?
a. consumer surplus falls from 1+2+3 to 1+2
b. consumer surplus rises from 1+4 to 4+6
c. consumer surplus rises from 1 to 1+2+3
d. consumer surplus rises from 1 to 1+2+4
e. consumer surplus does not change
16. Use the graph on the right for the following question. Which of the
following is correct?
a. total expenditure is 3+5 when the price is Pb
b. total expenditure is 1+2+3 when the price is Pa
c. total expenditure is 3+5+6 when the price is Pb
d. total expenditure is 4+5 when the price is Pb
e. none of the above is correct
17. Use the graph below. What is the change in producer surplus as price
falls from P2 to P1?
a. from D+E to A+B
b. from A+B to D + E
c. from A + D to A
d. from B+E to B
e. none of these

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25

What are Externalities?

Our lives are affected by the actions of many individuals, and as much as would like to control
our lives, some factors are clearly beyond our control. The time we spend commuting to class or
jobs is affected by how many other people decide to leave at the same time. It is easier to fall
asleep at night when our neighbors (and their dogs) are quiet. The actions of others may also be
beneficial. Medical scientists who find new cures for illnesses and quite neighbors who keep tidy
lawns exert positive influences on our lives.
Markets can be efficient only when market participants consider all the benefits and costs of their
actions. When individuals do not pay for all the resources that they use, negative externalities, or
external costs, are said to exist. A negative externality may arise, for example, when homeowners
are subjected to the noise created by a nearby factory producing toys. That factory is imposing a
cost (noise) on homeowners that is not paid for by factory owners and therefore allocates too
many resources in this market. That is, too much production of toys occurs.
Positive externalities occur whenever private markets fail to allocate resources on the basis of
social benefits. While all neighbors property values rise because the Smiths keep a tidy lawn,
those neighbors do not have to pay the Smiths for those higher values. The Smiths, however, may
not consider the beneficial effects on others when they make decisions about the quantity of
resources to allocate in maintaining a tidy lawn. Market allocate too few resources to activities
when individuals do not fully take account of the benefits of their actions on others. That is, too
little production of tidy lawns occurs.

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26

Negative externalities arise when there is a divergence between private costs and social costs. Private
costs are costs occurred by private parties. Private costs include only those paid by the producer and
therefore do not necessarily include the costs of all resources used in production. In the previous
example, a toy factory that does not pay for the noise pollution it inflicts on nearby homeowners only
consider their private costs of production (i.e., labor, tools, electricity, rent, etc.)
Social costs are those incurred by private parties in addition to any other costs borne by other members
of society. In our factory example, the difference between private and social costs is the discomfort that
the factory imposes on homeowners. The negative externality is this difference between private and
social costs and explains why it is sometimes referred to as an external cost.

$
Pe
P1

social costs

private costs

a
c

D
Qe Q1

toys

The graph shows both private and social costs in

producing toys. Note that social costs lie above
private costs, with the vertical distance between
the two curves reflecting the level of negative
externality. For example, at market equilibrium
Q1, distance bc measures the negative
externality per unit of production.
An efficient level of production would consider all
costs and occurs at the intersection of demand
and social costs curve at point a.

Markets will produce too much at Q1 and charge too little with P1. An efficient outcome would be
to produce less at Qe and charge a higher price at Pe.
27
efficient markets

Positive externalities arise when there is a divergence between private benefits and social benefits.
Positive externalities thus occur whenever markets fail to allocate on the basis of full social benefits.
Immunization against communicable diseases is a common example of a good that produces positive
externalities individuals who do not consume the good benefit because inoculations decrease the
number of individuals who may transmit diseases.
Markets do not take account of the benefits that flow to those who are not inoculated. However, those
benefits, which are external to the market exchange, are part of the benefits that society receives when
resources are allocated to immunization. Private producers do not normally care about non-paying
customers and thus will ignore external benefits to their production thus resulting in too little
production from the point of view of society.

$
c
Pe
P1

social costs
b

social benefits
private benefits
Q1 Qe

inoculations

The graph shows both private and social benefits

in producing inoculations. Note that social
benefits lie above private benefits, with the vertical
distance between the two curves reflecting the
level of positive externality. For example, at
market equilibrium Q1, distance ac measures
the positive externality per unit of production.
An efficient level of production would consider all
benefits and occurs at the intersection of social
benefits and social costs curve at point b.

Markets will produce too little at Q1 and charge too little with P1. An efficient outcome would be to
produce more at Qe and charge a higher price at Pe.
28
efficient markets

True-False
18. Negative Externalities arise whenever markets fail to allocate resources on the basis of full social cost.
19. Too many resources are allocated in markets with positive externalities.
20. Social costs are larger than private costs in markets characterized by negative externalities.
Multiple Choice
21. Which of the following is most likely to be associated with a positive externality?
a. air pollution
b. water pollution
c. inoculations for transmittable diseases
d. congestion on a crowded highway
22. When there is a divergence between social and private costs, which of the following arises?
a. positive externality
b. negative externality
c. public good
d. social good
23. Which of the following is said to occur when a market characterized by social benefits being larger than
private benefits?
a. positive externality
b. negative externality
c. Pareto equilibrium
d. Giffin good

efficient markets

29

Key Concepts
Total Welfare
Consumer Surplus
Maximum Price Consumers Willing to Pay
Producer Surplus
Minimum Prices Sellers are Willing to Accept
Do Not Confuse Consumer Surplus /Producer Surplus with Market Surplus
Walking Consumers Down a Demand Curve
Consumer Surplus Rises (Falls) with Lower (Higher) Prices
Producer Surplus Rises (Falls) as Price Rises (Falls)
Total Expenditure
Total Surplus at Market Equilibrium
Equilibrium as an Efficient Point in a Market
Price Ceiling vs. Price Floor
Shortages as Symptoms of Price Ceilings
Surpluses as Symptoms of Price Floors
Resource Misallocation (Inefficient Resource Allocation)
Deadweight Loss
Law of Unintended Consequences
Costs and Benefits of Price Ceilings/Floors
Minimum Wage Laws
2 Types of Unemployment Created by Minimum Wage Laws
Negative Externalities and Positive Externalities: When Markets are not Efficient
Private Costs vs. Social Costs; Private Benefits vs. Social Benefits.
Resource Misallocation Under Externalities
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30

1A
2B
3B
4D
5B
6A
7B
8C
9A
10A
11D
12C
13E
14D
15D
16A
17C.
18T
19F
20T
21C
22B
23A

efficient markets

31