Video tutorial: Efficiency in competitive markets - YouTube

8.5: 'Competitive equilibrium gains  from trade allocation and distribution'.  

As economists, we always say competitive markets  are efficient, competitive markets are efficient,  

but what do we mean by that? We mean that  the competitive markets maximise the mutual

benefits for the consumers and producers. Let me  explain. Let's focus on the benefits going to the

consumers. We call that consumer surplus. Let's  focus on the customer who is buying the 1,000

loaves of bread. When that customer is walking off  the bakery, he must have a smile on his face, why?

Because he bought that loaf of bread for €2 while  he was willing to pay a much higher price for

that bread. So that was a surplus going to that  consumer. Have you found yourself in a situation

that you purchased the product and secretly  you were willing to pay a much higher price

for that product? That was a consumer surplus  going to you. Let me give you another example.

Let's focus on the customers who purchased  the 3,000 loaves of bread. Again that customer

is happy when he's walking off the bakery, why?  Because he purchased the loaf of bread for €2

while he was willing to pay a higher price than  €2, but this time you see the consumer surplus

is smaller compared to the previous customer,  so this area represents all the surplus going

to the consumers, why? Because all the demanders  here, on our demand line, were willing to buy

bread a loaf of bread for a price higher than  €2 but in the end they end up just paying €2.

We can think about the same concept but from  a perspective of firms. We call that producer

surplus. Let's focus on the baker who's selling  the 1,000 loaves of bread. That baker must have

a smile at the time he's selling that bread, why?  Because he's selling that loaf of bread at a much

higher price than he was willing to supply that  bread at. Remember: this is the supply curve,

which in this case is the same as the marginal  cost curve, because we are operating on the

competitive market. So, just to repeat: that  baker is selling the bread at a much higher price

than he was willing to supply that bread at, and  that difference is a producer surplus - a benefit

going to the baker. So if we put these  two sides together, we realise that when

the baker was selling the 1,000 loaves of bread  and the customer was buying that loaf of bread,

they both benefitted from this transaction.  There was a surplus going to the consumer

and a surplus going to the producer. However,  this does not mean that both of these sides

equally benefit if, for instance, in the case  of the 1,000 loaves of bread you see that the

benefits going to the consumer is higher  than the benefits going to the producer.

But from an aggregate perspective, you see that  the competitive markets maximise this area.

They maximise the surplus going to the consumers  and producers. They maximize the joint surplus.

Finally, let me compare a competitive market  with the monopoly market from a perspective of

efficiency. Let me start with the monopoly market.  The most important thing here is that we have

wasted opportunities. We've got a deadweight loss  which we show in this graph by this area. Now,

let me explain to you how a monopoly ends  up hurting the consumers. At the moment,

Beautiful Cars is maximising their profits  by charging $5,440 for each of their cars.

Remember: they're pricing  each of their cars the same

and they are selling 32 cars overall and  this way they're maximising their profits.

Now let's assume we have a customer, an  additional customer who wants to buy the

33rd car and that customer is willing to pay  around $4,000, let's say, for that additional car.

At the same time, the cost of producing  another car, the marginal cost of the 33rd

car for Beautiful Cars is lower than the  price that that customer is willing to pay,

but Beautiful Cars never produces the 33rd  car, why? Because if they want to serve

that customer they have to lower their price  for all of their cars and they end up making

less profit on the other 32 cars and in this  way they end up making a lower total profit.

Because of that, Beautiful Cars stops at 32 cars  and they decide not to serve that 33rd customer

and in this way you see a wasted opportunity: a  consumer benefit that was never realised. This is

a good example of how a monopoly market is not  efficient. Now let me focus on the competitive

market. There you got no missed opportunities:  all the mutually beneficial transactions that

could have taken place between the consumers  and producers have actually taken place. There

is no deadweight loss. The competitive market  has maximised the surplus going to the consumers

and producers and in that sense we say that  competitive markets are Pareto efficient.