Community surplus and allocative efficiency

Overview

Community surplus and difference between productive efficiency and allocative efficiency.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Define community surplus.

   Model answer

   Community surplus, also called total or economic welfare, is the sum of consumer surplus and producer surplus in a market. It measures the total net gain that buyers and sellers together obtain from trading, over and above the value of the resources used. It is shown on a diagram as the whole area between the demand curve and the supply curve up to the quantity traded.

2. 2

   Describe how community surplus is shown on a demand and supply diagram, naming the axes.

   Model answer

   Put price on the vertical axis and quantity per period on the horizontal axis, and draw demand sloping down and supply sloping up, crossing at price P1 and quantity Q1. Consumer surplus is the area below the demand curve and above the horizontal line at P1, up to Q1. Producer surplus is the area above the supply curve and below that same line. Community surplus is the two combined, which is the whole triangle enclosed between the demand curve above and the supply curve below, from the vertical axis across to Q1.

3. 3

   Explain why community surplus is at a maximum where demand and supply intersect.

   Model answer

   The height of the demand curve is the value consumers place on each unit and the height of the supply curve is the cost of producing it. Every unit up to the intersection is valued more highly than it costs, so producing it adds to community surplus. Beyond the intersection each unit costs more than it is worth to any consumer, so producing it subtracts from surplus. The total is therefore greatest at exactly the quantity where value and cost are equal, which is the equilibrium quantity.

4. 4

   Define allocative efficiency and state the condition for it in a single market.

   Model answer

   Allocative efficiency is achieved when resources are used to produce the combination of goods that society values most highly, so that no reallocation could make anyone better off without making someone worse off. In a single market the condition is that price equals marginal cost, because price measures the value consumers place on the last unit and marginal cost measures the value of the resources used to make it. Where the two are equal, output is at the level that maximises community surplus.

5. 5

   Explain why the equilibrium of a competitive market satisfies the condition for allocative efficiency.

   Model answer

   The supply curve in a competitive market is the marginal cost curve, because firms expand output until the price they receive equals the cost of the last unit. At the intersection with demand, the price is also equal to the value consumers place on the last unit. Price therefore equals both marginal cost and marginal benefit at the equilibrium quantity, which is exactly the condition for allocative efficiency.

6. 6

   Explain what happens to community surplus if output is restricted below the free market equilibrium quantity.

   Model answer

   Every unit between the restricted quantity and the equilibrium quantity is valued by consumers at more than it costs to produce, so each one that is no longer made destroys the difference between its value and its cost. The lost surplus is the triangle between the demand curve above and the supply curve below, running from the restricted quantity across to the equilibrium quantity. This is a deadweight loss: it is not transferred to anyone, it simply disappears.

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