Market efficiency
Why a competitive market's equilibrium makes total surplus as large as it can be, and the limits of that result.
FinanceA company's marketAbout 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Define total surplus and efficiency
- State Mankiw's three insights about free-market outcomes
- Name the limits of the efficiency result
Builds toward: Judge a company. Read a company's accounts, apply Graham's tests, and make a rough valuation.
A company's market: pricing power, taxes and trade: lesson 4 of 15
- A company's market
- Price elasticity of demand 6 min
- Elasticity and total revenue 5 min
- Consumer and producer surplus 4 min
- Market efficiency 5 min
- Price ceilings and floors 6 min
- Who really pays a tax 5 min
- Deadweight loss 5 min
- How tax size changes the loss 5 min
- Absolute and comparative advantage 5 min
- Why trade helps both sides 5 min
- Winners and losers from trade 5 min
- Tariffs and quotas 5 min
- What makes productivity grow 5 min
- Growth policy 5 min
- Why unemployment exists 6 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 7
What it is
Total surplus = consumer surplus + producer surplus = value to buyers − cost to sellers. (The price paid cancels out: it is a cost to buyers and an income to sellers.)
An allocation of resources is efficient if it makes total surplus as large as possible. Equality is about whether well-being is spread evenly across people. The two are different questions.
Mankiw imagines a benevolent social planner: all-knowing, all-powerful and well-meaning, wanting to make society as well off as possible. What should the planner do with a competitive market? Mankiw's answer comes in three insights about the free-market outcome:
- It gives the good to the buyers who value it most (those whose willingness to pay is at least the price).
- It gives the job of producing it to the sellers with the lowest costs (those whose cost is at most the price).
- It produces the quantity that maximises total surplus. Producing more would mean making units that cost more than buyers value them; producing less would leave out units buyers value at more than they cost.
So the equilibrium is efficient, and the planner can leave it alone. Mankiw notes the French term for this policy: laissez faire, "allow them to do".
Quick check
Tap an answer to check it.
A buyer values a unit at 30; it costs a seller 35 to make. Should it be produced, to maximise total surplus?
- The price only moves surplus between them; value 30 against cost 35 loses 5 in total
Show answer
No: it would reduce total surplus by 5. Total surplus = value − cost, and 30 − 35 is negative.
Why it matters
This is the reasoning behind Adam Smith's invisible hand: buyers and sellers each look after themselves, yet prices guide them to an outcome that maximises total surplus.
The limits. Mankiw flags two assumptions behind the result, and a separate concern:
- Market power. If one buyer or seller (or a small group) can control prices, the market can be inefficient, because price and quantity are held away from the equilibrium.
- Externalities. If a market affects people outside it, as pesticide pollution affects people who breathe the air or drink the water, total surplus in the market leaves out costs or benefits to others.
- Equality, a separate concern. Efficiency says nothing about fairness. A policymaker may care how the pie is shared, not just its size.
When markets fail in these ways, public policy can sometimes improve the outcome, a theme for later chapters.
Worked example
Four buyers would pay 50, 40, 30 and 20 for a good. Four sellers can make one each at costs of 10, 20, 30 and 40. The market price is 30.
- Buyers who buy: those valuing it at 30 or more (50, 40, 30). Sellers who sell: those with costs of 30 or less (10, 20, 30). Three units trade.
- Total surplus = value − cost = (50 + 40 + 30) − (10 + 20 + 30) = 120 − 60 = 60.
Could a planner do better?
- A 4th unit would go to the buyer valuing it at 20 and be made by the seller costing 40: −20. Total falls to 40.
- Dropping the 3rd unit (value 30, cost 30) leaves total at 60: that unit adds nothing.
- Swapping the 50-buyer for the 20-buyer would lose 30.
The market outcome, three units, gives the largest total surplus.
Common mistake
Reading "efficient" as "fair" or "good in every way". An efficient outcome makes the pie as big as possible; it doesn't say whether the slices are fair, and it assumes there is no market power and no external effect.
Key terms
- total surplus
- consumer surplus plus producer surplus: value to buyers minus cost to sellers
- efficiency
- the property of an allocation that maximises total surplus
- equality
- the property of distributing economic well-being evenly
- benevolent social planner
- Mankiw's imaginary all-knowing, well-meaning decision maker, used to judge market outcomes
- market power
- the ability of a single buyer or seller, or a small group, to influence prices
- externality
- an effect of a market on people who are not buyers or sellers in it
- laissez faire
- the policy of leaving markets alone
Practise the key terms
Tap a card to turn it over. 7 cards.
| Front | Back |
|---|---|
| total surplus | consumer surplus plus producer surplus: value to buyers minus cost to sellers |
| efficiency | the property of an allocation that maximises total surplus |
| equality | the property of distributing economic well-being evenly |
| benevolent social planner | Mankiw's imaginary all-knowing, well-meaning decision maker, used to judge market outcomes |
| market power | the ability of a single buyer or seller, or a small group, to influence prices |
| externality | an effect of a market on people who are not buyers or sellers in it |
| laissez faire | the policy of leaving markets alone |
Practice
Work it through
Buyers value a good at 45, 35 and 25. Sellers' costs are 15, 25 and 40. The price is 30.
- Buyers at 45 and 35; sellers at 15 and 25
- 45 + 35
- 15 + 25
- 80 − 40
Quick quiz
Tap an answer to check it.
In the last exercise, would a third unit raise total surplus?
- It would add value 25 at cost 40, a loss of 15
Show answer
No: its value (25) is below its cost (40). Producing beyond the equilibrium adds units that cost more than they are worth.
Which of these is a reason a market may not be efficient, in Mankiw's account?
- That moves surplus between buyers and sellers, not efficiency
- Equality is a separate question
Show answer
One firm can control the price. Market power keeps price and quantity away from the equilibrium.
What does the price paid do to total surplus?
- Total surplus is value minus cost; the price drops out
Show answer
Nothing: it is a cost to buyers and an income to sellers, so it cancels. Total surplus = value to buyers − cost to sellers.
In short
- Total surplus = value to buyers − cost to sellers.
- Free markets give goods to those who value them most, production to those with lowest costs, and the surplus-maximising quantity.
- So a competitive equilibrium is efficient: Smith's invisible hand.
- Limits: market power, externalities, and the separate question of equality.
Mastery check
Answer without looking back. Score 80% or more and the lesson is marked done. Your result is kept only in this browser.
Check yourself
Answer in your head first, then open the answer. Nothing is saved.
What is efficiency in Mankiw's sense?
Show answer
An allocation of resources that maximises total surplus.
Name the two market failures Mankiw mentions here.
Show answer
Market power and externalities.
In the worked example, what is total surplus at the market outcome?
Show answer
60.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 7.
- On this site: Consumer and producer surplus.
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