EVALUATING THE MARKET EQUILIBRIUM
Figure 7 shows consumer and producer surplus when a market reaches the equilibrium of supply and demand. Recall that consumer surplus equals the area above the price and under the demand curve and producer surplus equals the area below the price and above the supply cure Thus, the total area between the supply and demand curves up to the point of equilibrium represents the total surplus in this market Is this equilibrium allocation of resources efficient? Does it maximize total surplus To answer these questions, keep in mind that when a market is in equilibrium, the price determines which buyers and sellers participate in the market. Those buyers who value the good more than the price (represented by the segment AE on the demand curve) choose to buy the good; buyers who value it less than the price (represented by the segment EB) do not. Similarly, those sellers whose costs are less than the price (represented by the segment CE on the supply curve) choose to produce and sell the good; sellers whose costs are greater than the price (represented by the segment ED) do not These observations lead to two insights about market outcomes.
1. Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay.
2. Free markets allocate the demand for goods to the sellers who can produce them at least cost Thus, given the quantity produced and sold in a market equilibrium, the social planner cannot increase economic well-being by changing the allocation of consumption among buyers or the allocation of production among sellers.
3. Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.
Figure 8 illustrates why this is true. To interpret this figure, keep in mind that the demand curve reflects the value to buyers and the supply curve reflects the cost to sellers. At any quantity below the equilibrium level, such as Q the value to the marginal buyer exceeds the cost to the marginal seller. As a result, increasing the quantity produced and consumed raises total surplus.
This continues to be true until the quantity reaches the equilibrium level. Similarly, at any quantity above the equilibrium level, such as Q2, the value to the marginal buyer is less than the cost to the marginal seller. In this case, decreasing the quantity raises total surplus, and this continues to be true until quantity falls to the equilibrium level To maximize total surplus, the social planner would choose the quantity where the supply and demand curves intersect Together, these three insights tell us that the market outcome makes the sum of consumer and producer surplus as large as it can be. In other words, the equilibrium outcome is an efficient allocation of
resources. The benevolent social planner can, therefore, leave the market outcome just as he finds it. This policy of leaving well enough alone goes by the French expression laissez faire, which literally translated means “allow them to do Society is lucky that the planner need to intervene. Although it has been a useful exercise imagining what an all-knowing, all-powerful, well-intentioned dictator would do, let’s face it: Such characters are hard. to come by. Dictators are rarely as benevolent as our assumed one. And even if we found someone so virtuous, he would lack crucial information
Suppose our social planner tried to choose an efficient allocation of resources on his own, instead of relying on market forces. To do so, he would need to know the willingness to pay of every potential buyer in the market and the cost of every potential seller. And he would need this information not only for this market but for every one of the many thousands of markets in the economy The task is practically impossible, which explains why centrally planned economies never work very well The planner’s job becomes easy, however, once he takes on a partner Adam Smith’s invisible hand of the marketplace. The invisible hand takes all the about buyers and sellers into account, guiding everyone in the market to the best outcome as judged by the standard of economic efficiency. It is, truly a remarkable feat. That is why economists so often advocate free markets as the best way to organize economic activity.