Chapter 11: Markets, Efficiency
and the Public Interest
11.1 Efficiency under perfect competition
Social efficiency: ‘Pareto optimality’
Pareto improvement Where changes in production or consumption can make at least one
person better off without making anyone worse off.
Social efficiency A situation of Pareto optimality.
Pareto optimality Where all possible Pareto improvements have been made; where,
therefore, it is impossible to make anyone better off without making someone else worse
off.
The simple analysis of social efficiency: marginal benefit and
marginal cost
A rational person will choose to do an activity if the gain from so doing exceeds any sacrifice
involved.
The term ‘cost’, they are referring to ‘opportunity cost’: in other words, the sacrifice of
alternatives.
When we say that the marginal benefit of an activity is greater than its marginal cost, we
mean that the additional benefit gained exceeds any sacrifice in terms of alternatives
forgone.
Rational economic behaviour Doing more of those activities whose marginal benefit
exceeds their marginal cost and doing less of those activities whose marginal cost exceeds
their marginal benefit.
Private efficiency Where a person’s marginal benefit from a given activity equals the
marginal cost.
social efficiency will be achieved where, for any activity, the marginal benefit to society
(MSB) is equal to the marginal (opportunity) cost to society (MSC):
MSB = MSC
Economists argue that under certain circumstances the achievement of private efficiency will
result in social efficiency also. Two major conditions have to be fulfilled, however:
▪ There must be perfect competition
▪ There must be no externalities.
Externalities Costs or benefits of production or consumption experienced by society
but not by the producers or consumers themselves. Sometimes referred to as ‘spill-
over’ or ‘third-party’ costs or benefits.
Achieving social efficiency through the market
Consumption: MU = P
The marginal benefit to a consumer from the consumption of any good is its marginal utility.
The marginal cost is the price the consumer has to pay.
As we have seen, an individual’s consumer surplus is maximised at the output where MU =
P. With all consumers doing this, and all facing the same market price, their collective
consumer surplus will be maximised.
, Consumers’ total utility is given by the area under the demand (MU) curve (areas A + B + C).
Consumers’ total expenditure is P × Q (areas B + C). Consumer surplus is the difference
between total utility and total expenditure: in other words, the area between the price and
the demand curve (area A).
Production: P = MC
The marginal benefit to a producer from the production of any good is its marginal revenue
(which under perfect competition will be the same as the price of the good).
Total producer surplus Total revenue minus total variable costs (TR − TVC): in other words,
total profit plus total fixed costs (TΠ + TFC).
Private efficiency in the market: MU = MC
In Figure 11.1, both consumer surplus and producer surplus are maximised at output Qe.
This is the equilibrium output under perfect competition. Thus, under perfect competition,
the market will ensure that total surplus (areas A + B), sometimes called total private
surplus, is maximised. At this output, MU = P = MC.
Total(private)surplus Total consumer surplus (TU−TE) plus total producer surplus (TR − TVC).
Social efficiency in the market: MSB = MSC
Provided the two conditions of (a) perfect competition and (b) the absence of externalities
are fulfilled, Pareto optimality (i.e. social efficiency) will be achieved.
- Perfect competition
MU = MC
- No externalities
MSB = MU = P = MC = MSC
MSB = MSC
Total social surplus Total benefits to society from consuming a good minus total costs
to society from producing it. In the absence of externalities, total social surplus is the
same as total (private) surplus.
Inefficiency would arise if (a) competition were not perfect and so marginal revenue were
not equal to price and as a result marginal cost were not equal to price; or (b) there were
externalities and hence either marginal social benefit were different from marginal utility
(i.e. marginal private benefit) or marginal social cost were different from marginal (private)
cost.
and the Public Interest
11.1 Efficiency under perfect competition
Social efficiency: ‘Pareto optimality’
Pareto improvement Where changes in production or consumption can make at least one
person better off without making anyone worse off.
Social efficiency A situation of Pareto optimality.
Pareto optimality Where all possible Pareto improvements have been made; where,
therefore, it is impossible to make anyone better off without making someone else worse
off.
The simple analysis of social efficiency: marginal benefit and
marginal cost
A rational person will choose to do an activity if the gain from so doing exceeds any sacrifice
involved.
The term ‘cost’, they are referring to ‘opportunity cost’: in other words, the sacrifice of
alternatives.
When we say that the marginal benefit of an activity is greater than its marginal cost, we
mean that the additional benefit gained exceeds any sacrifice in terms of alternatives
forgone.
Rational economic behaviour Doing more of those activities whose marginal benefit
exceeds their marginal cost and doing less of those activities whose marginal cost exceeds
their marginal benefit.
Private efficiency Where a person’s marginal benefit from a given activity equals the
marginal cost.
social efficiency will be achieved where, for any activity, the marginal benefit to society
(MSB) is equal to the marginal (opportunity) cost to society (MSC):
MSB = MSC
Economists argue that under certain circumstances the achievement of private efficiency will
result in social efficiency also. Two major conditions have to be fulfilled, however:
▪ There must be perfect competition
▪ There must be no externalities.
Externalities Costs or benefits of production or consumption experienced by society
but not by the producers or consumers themselves. Sometimes referred to as ‘spill-
over’ or ‘third-party’ costs or benefits.
Achieving social efficiency through the market
Consumption: MU = P
The marginal benefit to a consumer from the consumption of any good is its marginal utility.
The marginal cost is the price the consumer has to pay.
As we have seen, an individual’s consumer surplus is maximised at the output where MU =
P. With all consumers doing this, and all facing the same market price, their collective
consumer surplus will be maximised.
, Consumers’ total utility is given by the area under the demand (MU) curve (areas A + B + C).
Consumers’ total expenditure is P × Q (areas B + C). Consumer surplus is the difference
between total utility and total expenditure: in other words, the area between the price and
the demand curve (area A).
Production: P = MC
The marginal benefit to a producer from the production of any good is its marginal revenue
(which under perfect competition will be the same as the price of the good).
Total producer surplus Total revenue minus total variable costs (TR − TVC): in other words,
total profit plus total fixed costs (TΠ + TFC).
Private efficiency in the market: MU = MC
In Figure 11.1, both consumer surplus and producer surplus are maximised at output Qe.
This is the equilibrium output under perfect competition. Thus, under perfect competition,
the market will ensure that total surplus (areas A + B), sometimes called total private
surplus, is maximised. At this output, MU = P = MC.
Total(private)surplus Total consumer surplus (TU−TE) plus total producer surplus (TR − TVC).
Social efficiency in the market: MSB = MSC
Provided the two conditions of (a) perfect competition and (b) the absence of externalities
are fulfilled, Pareto optimality (i.e. social efficiency) will be achieved.
- Perfect competition
MU = MC
- No externalities
MSB = MU = P = MC = MSC
MSB = MSC
Total social surplus Total benefits to society from consuming a good minus total costs
to society from producing it. In the absence of externalities, total social surplus is the
same as total (private) surplus.
Inefficiency would arise if (a) competition were not perfect and so marginal revenue were
not equal to price and as a result marginal cost were not equal to price; or (b) there were
externalities and hence either marginal social benefit were different from marginal utility
(i.e. marginal private benefit) or marginal social cost were different from marginal (private)
cost.
