Lesson 5 – Market Efficiency

Functions of the price mechanism (resource allocation, signalling, incentive, rationing)

From your course document

Functions of the price mechanism (resource allocation, signalling, incentive, rationing)

Consumer and producer surplus

Social Community surplus

Allocative efficiency at the competitive market equilibrium (social community surplus maximised
at equilibrium)

Marginal benefits (MB) equals marginal cost (MC)

Sections to read from your textbook:

Section 2.5

In the previous lesson you saw how the intersection of the supply and demand curve determine the
market equilibrium. Market equilibrium will occur at a price where the quantity supplied equals the
quantity demanded (thus resulting in a ‘quantity sold’).

We also saw how if a non-price determinant of supply or demand changes then the price will go up
or down and this will signal to producers and consumers to change how much they supply or
demand resulting in a new quantity sold. This way, the ‘price signal’ automatically changes how
resources are allocated toward the production of a good or service when conditions of supply or
demand change without anybody having to do any overall ‘organising or planning’ of the economy.
This process is known as ‘the price mechanism’ and foundational economist Adam Smith referred to
it as ‘the invisible hand of the market’. Can you think why?

How all of this relates to ‘best solving the economic problem’

Recall all the way back to the economic problem. The economic problem is about ‘how society best
allocates its scarce resources to satisfy needs and wants. In so doing, the society decides:-

 What to produce;
 How to produce;
 And who gets what.

The price mechanism is the main way this happens in a ’free market economic system’ and, more
appropriately in a ‘mixed market’ which relies mostly on free markets. Carefully read through page
63 to 65 with your teacher to gain an understanding of how the price mechanism does this. Take
your own notes!

Then Complete Test Your Understanding 2.7.

How do you show that we gain satisfaction because of the operation of the free markets?
Producer Surplus, Consumer Surplus and Allocative Efficiency

Recall that ‘allocative efficiency’ involves solving the economic problem by allocating our resources
in a way that maximises utility (wellbeing or satisfaction) and minimises opportunity cost. To
understand how this can be demonstrated in the free market you will need to read under the
heading “Allocative Efficiency in Competitive Markets” on page 65 of your text.

To get this. You will need to understand that the demand curve can also be called a ‘marginal
benefit curve’. This is because it actually represents the ‘extra benefit’ that you get from consuming
an additional unit of the good or service you are purchasing. Your teacher will explain this using an
even more complicated term ‘diminishing marginal benefit’. You will have to listen carefully. This is
difficult!

Once you get this, your teacher will explain that the supply curve is, in fact, a ‘marginal cost curve’.
Listen carefully …

So why is the equilibrium the intersection of supply and demand the ‘best allocation of resources to
maximise satisfaction’.

Cast your eyes on figure 2.17 of your text on page 67.

Imagine that the economy was producing Qa amount of the good shown in that figure. This is below
the equilibrium, If that was the case, consumers would be willing to pay P2 for that particular unit of
the good – that’s their marginal benefit. Yet producers would only face a marginal cost of P5. P2 is
greater than P5, the satisfaction is greater than the ‘opportunity cost’. So there is more satisfaction
than it costs to produce the good, so the economy will definitely be better off by producing that
amount. Should the economy produce more? What if output was increased to Qb? Marginal
Benefit of producing that last unit (P3) is still greater than the marginal cost of that last unit (P4) so
the economy should keep on producing. This should continue until we reach the equilibrium where
we have the maximum benefit to society. This is precisely what happens in a free market!

But who gets the benefit?

The consumer gets the benefit of any satisfaction that is more than they had to pay and you can
show exactly how much on the graph! Consumers are satisfied by how much they are prepared to
pay, that is greater than how much they actually did pay. This is called ‘consumer surplus’ and is
shown on the graph. Your teacher will explain it.

The producer gets the benefit of the amount of price they actually receive over and above their
costs. This is called ‘producer surplus’ and is shown on the graph. When you combine them, you get
the total amount of satisfaction that providing the good gives people – producers and consumers.
This called social surplus or community surplus. You can now read all about this with your teacher.
Note, that at SL you do NOT HAVE TO DO ANY OF THOSE FUNKY CALCULATIONS in the section of the
book to which you are being referred.

Once you understand this, read through ‘Adam Smith’s Invisible Hand’ and ‘Allocative efficiency of
Markets vs Government Intervention’ with your teacher.

Try the following exercises with your teacher to see how well you get these ideas in practice:_

Producer Surplus
1. Fill in the missing blanks
The market for any good or service clears at the point where the ___________ for the product
equals the _______________. At this point the market or community surplus is
______________. A market or community surplus is the aggregate of producer and consumer
surplus. Producer surplus is defined as the difference between the market price received by a
firm and the price which they would be willing and able to produce the the good or service for. It
is illustrated on a diagram by the area ______________ the supply curve and
__________________ the market price level. If the supply curve shifts to the left, the producer
surplus will ________________ assuming that demand remains unchanged.
2. Increase or Decrease? State whether producer surplus will increase or decrease for the
products in the following scenarios

Product Scenario Change in producer surplus

Cotton jeans The price of cotton increases

Manchester United
The club win the Premier League
football shirts

The government remove all taxes on

Tobacco products
tobacco

A medical reports suggest that sugar

Chocolate bars
products are linked to obesity
Answers

1. Fill in the missing blanks

The market for any good or service clears at the point where the demand for the product
equals supply. At this point the market or community surplus is maximised. A market or
community surplus is the aggregate of producer and consumer surplus. Producer surplus is
defined as the difference between the market price received by a firm and the price which they
would be willing and able to produce the the good or service for. It is illustrated on a diagram by
the area above the supply curve and below the market price level. If the supply curve shifts to the
left, the producer surplus will fall assuming that demand remains unchanged.

2. Increase or Decrease? State whether producer surplus will increase or decrease for the
products in the following scenarios

Product Scenario Change in producer surplus

Cotton jeans The price of cotton increases Falls

Manchester United
The club win the Premier League Rises
football shirts

The government remove all taxes on

Tobacco products Rises
tobacco

A medical reports suggest that sugar

Chocolate bars Falls
products are linked to obesity

Consumer Surplus
3. Fill in the missing blanks
Consumer surplus is defined as the difference between the market price paid by a consumer and
the price which they would be willing and able to purchase the the good or service for. It is
illustrated on a diagram by the area ______________ the demand curve and
__________________ the market price level. If the demand curve shifts to the left, the consumer
surplus will ________________ assuming that supply remains unchanged.
4. Increase or Decrease?
State whether consumer surplus will increase or decrease for the products in the following
scenarios

Product Scenario Change in consumer surplus

Playstation computer
The price of a PlayStation falls
games

Breakfast cereals A fall in the popularity of

 breakfast cereals

Christmas wrapping
A rise in the price of wood pulp
paper

The price of steel falls

Cars
considerably on global markets

Answers

3. Fill in the missing blanks

Consumer surplus is defined as the difference between the market price paid by a consumer and
the price which they would be willing and able to purchase the the good or service for. It is
illustrated on a diagram by the area below the demand curve and above the market price level. If
the demand curve shifts to the left, the consumer surplus will fall assuming that supply remains
unchanged.

4. Increase or Decrease?
State whether consumer surplus will increase or decrease for the products in the following
scenarios

Product Scenario Change in consumer surplus

Playstation computer
The price of a PlayStation falls Rises
games

A fall in the popularity of breakfast

Breakfast cereals Falls
cereals

Christmas wrapping paper A rise in the price of wood pulp Falls

The price of steel falls

Cars Rises
considerably on global markets

Now

Complete ‘Test Your Understanding 2.8