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.

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.  The South Bronx is a good example.  The local government may add ordinances to force landlords to maintain their properties, but this triggers a black-market rental market with illegal sublets.  This is standard practice in Manhattan.  It's a classic case of good intentions gone wrong.  In fact, it illustrates a basic less for economic policy-makers: "The road to hell is paved with good intentions!"

Unfortunately, governments often promulgate economically wasteful policies like this.  Here's another real-world example:

The US maintains strict quotas on sugar imports in order to protect US sugar beet producers.  This has lots of unintended consequences.  First, consumers spend more on sugar, and thus have slightly less income to spend on other goods.  Second, cropland gets diverted from other crops to sugar beets which increases the scarcity and prices of other crops to consumers, possibly causing the US to import more of those crops.  Third, US sugar beet producers don't benefit as much as they hoped, because the high price of sugar gives the market for artificial sweeteners a big boost, and artificial sweeteners can compete against high-priced sugar a lot more effectively than low-price sugar.  Without sugar quotas, some of these artificial sweeteners might never have been developed.  Similarly, corn is a big winner, since corn sweeteners can compete very nicely against high-priced US sugar.  Fourth, US import restrictions on sugar force efficient foreign sugar producers into other crops.  Since Columbia can't sell sugar to the US, it's grows and exports cocaine to the US instead, and we have lots of drug-related crime.  Next time you're mugged by a dope addict, thank America's sugar beet growers and the US Congressmen they bought.  The sugar beet lobby is still in Washington whining for even more government help.
 

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.