This course analyzes how market allocate resources between uses and through time. Briefly, we define economic efficiency as maximizing the stream of net benefits accruing from the resource stock across all uses and time periods.

Net benefits are defined as total benefits minus total costs.  Consider the simple market model below, where the equilibrium quantity and price are determined by the intersection of the supply and demand schedules.

This market has no price discrimination, which means that all consumers pay the same price per unit, regardless of how much more they might actually be willing to pay.  In fact, there are consumers represented all along the demand schedule above the equilibrium price who would be willing to pay differential premiums for the good.  These consumers benefit by these extra amounts they don't have to pay.  This aggregate consumer benefit is calculated as the triangular area beneath the demand schedule and above the equilibrium price, and is termed consumer surplus.

Similarly, producers all receive the same price per unit, regardless of how much less they might actually be willing to sell for.  The producers represented on the portion of the supply schedule below the equilibrium price would be willing to sell for various discounts.  These producers benefit by not having to sell at these discounts.  This aggregate producer benefit is calculated as the triangular area above the supply schedule and below the equilibrium price, and is termed producer surplus.

Total benefits are measured as total willingness to pay--the area under the market demand curve up to the market equilibrium quantity. Total costs are measured as the area under the supply curve up to the market equilibrium quantity. Total benefits minus total costs equals total economic surplus, the sum of consumer surplus and producer surplus.

Consumer surplus is the total dollar amount consumers would be willing to pay for the market equilibrium quantity above what they actually do pay. Producer surplus is the total dollar amount producers actually receive for the market equilibrium quantity above what they would be willing to accept.

Market Distortions and Inefficiency

In general, competitive markets are efficient, and policies that distort markets typically result in economic waste.

Consider the effects of a market distortion, such as a rent-control policy in a city.  The following graph illustrates the consequences of a price-ceiling: supply is reduced, creating a black market price higher than the original equilibrium price.  The result is an economic deadweight loss (DWL) a quantitative measure of the aggregate economic waste caused by the policy: here the loss in producer surplus is far larger than any gain in consumer surplus.

As we discussed in a previous lecture, the long-term effects of an urban rent-control program can be devastating:  Rental caps leave landlords no incentive to maintain properties, the neighborhood becomes a slum, the tax base collapses, buildings are eventually abandoned and no new housing gets built.  This is what happened in the South Bronx. It's a classic case of well-intended market interventions yielding terrible unintended consequences. As the proverb says, "the road to hell is paved with good intentions"

Unfortunately, our political processes yield economically wasteful policies all too frequently. Several more real-world examples will be discussed in a subsequent lecture, and subjected to some "back of the envelope" analyses in your homework problems.
 

Preview: Efficiency through Time

An optimal allocation implies that the marginal net benefits accruing from the resource in each use are equal, and the time-discounted marginal net benefits accruing from the resource in each time period are equal.

Discounting allows us to compare net benefits across time periods. The discount rate is a social rate of time preference: we would rather have benefits today rather than next year, so we "discount" next years benefits slightly relative to current benefits. Financial interest rates reflect this discount rate as well as inflationary expectations and risk costs.

Students are frequently surprised to see that competitive markets can achieve near-optimal allocations of resources. Monopolistic markets generally result in excess conservation. Various other market failures also compromise allocative efficiency. For example, some "common property" or "open-access" resources such as marine fisheries are vulnerable to over-harvesting; non-excludable "public goods" such as scenic quality are typically under-supplied.