Lesson preview · Efficiency and market failure
Efficiency and market failure
~8 min · Free to read
Ana would happily pay 10 dollars for a sandwich. Her local café charges 6 dollars, so she is 4 dollars better off. The sandwich cost the café 3 dollars to make, so the café gains 3 dollars too. One trade, 7 dollars of gains, and nobody lost out.
Key Term
Consumer, producer and total surplus
- Willingness to pay (WTP) is the most a buyer would pay. Consumer surplus (CS) is willingness to pay minus the price: the buyer’s gain.
- Producer surplus (PS) is the price minus the lowest price the seller would accept. That is usually the extra cost of making the item: its marginal cost (MC).
- Total surplus is the two added together: the market’s whole gain from trade.
Here “surplus” means a gain, not a pile of unsold goods.
Line up a market’s buyers from keenest to least keen, and their willingness to pay traces out the demand curve. Everyone willing to pay at least the price buys, and each gains a thin bar between the curve and the price. With a straight-line demand curve, the bars fill a triangle: consumer surplus.
For consumer surplus, the base is the quantity bought. The height runs from the price up to where demand meets the price axis.
So a lower price makes consumer surplus bigger in two ways: buyers already in the market gain more, and new buyers join.
So a higher price makes producer surplus bigger in two ways: sellers already in the market earn more per widget, and new sellers join.
The two graphs’ curves cross at 8 dollars and 24 widgets. The 10th widget is worth 15 dollars to its buyer and costs 4.50 dollars to make, so trading it adds 10.50 dollars of surplus. The 30th is worth only 5 dollars but would cost 9.50 dollars, a loss of 4.50 dollars. Every widget before the 24th is worth more than it costs; every one after costs more than it is worth. So 24 widgets is the efficient quantity: no other quantity gives a bigger total surplus. The market reaches it on its own.
That result needs three main conditions. The market must be competitive: many buyers and sellers, none big enough to set the price. Its curves must count everyone’s costs and benefits. And both sides must know what they’re trading.
Key Term
Market failure
Market failure means the market makes the wrong quantity from society’s point of view: too much or too little. Then total surplus, counting everyone affected, is smaller than it could be. The main causes:
- Externalities: costs or benefits that land on people outside the deal, like factory smoke.
- Public goods: nobody can be stopped from using them, and one person’s use leaves no less for others, like street lights. Each waits for others to pay, so too few get provided.
- Common resources: anyone can take them, but each one taken leaves less for others, like fish in the open sea. So they get overused.
- Information gaps: one side knows far more, like a used car’s seller.
- Market power: a single big seller (a monopoly) makes less so it can charge more.
Trap · Common Misconception
A price rise is not a market failure
A storm wrecks half a region’s banana farms, and banana prices double. That hurts, but the market is working. The high price shares out the scarce bananas and tells growers to plant more. Market failure is about the wrong quantity, not an unwelcome price.
Trap · Common Misconception
Efficient is not the same as fair
An efficient market makes total surplus as big as possible but says nothing about who gets it. A concert ticket goes to the fan who will pay most, who may just be the richest. Economists judge efficiency (how big the gains are) and equity (how fairly they’re shared) separately.
Check yourself · no marks
Market failure, or just a price change? Sort each one.
- A storm shuts several oil refineries, and petrol prices jump.
- A chemical plant’s waste kills a river’s fish, and fishers downstream lose their income.
- A village has no street lights, because each family waits for the others to pay.
Commit to one first. Guessing and being wrong beats reading the answer cold.
Worked Example
In the widget market, demand meets the price axis at 20 dollars and supply at 2 dollars. At a price of 8 dollars, 24 widgets are sold. Find consumer, producer and total surplus.
Practice · 1 / 7
Tomas would pay up to 40 dollars for a book. He buys it for 25 dollars. What is his consumer surplus?
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