4 Efficiency and the Idealized Competitive

Model

Collective action enables societies to produce, distribute, and consume a great variety and
abundance of goods. Much collective action arises from voluntary agreements among
people—within families, private organizations, and exchange relationships. The policy
analyst, however, deals primarily with collective action involving the legitimate coercive
powers of government: public policy encourages, discourages, prohibits, or prescribes
private actions. Beginning with the premise that individuals generally act in their own best
interest, or at least what they perceive as their self-interest, policy analysts have to provide
rationales for any governmental interference with private choice. The task applies to the
evaluation of existing policies as well as to new initiatives. As our case chapters show, it
is an essential step in any comprehensive analysis and will often provide the best initial
insight into complex situations.
Our approach to classifying rationales for public policy begins with the concept of
a perfectly competitive economy. One of the fundamental bodies of theory in modern
economics deals with the properties of idealized economies involving large numbers of
profit-maximizing firms and utility-maximizing consumers. Under certain assumptions,
the self-motivated behaviors of these economic actors lead to patterns of production
and consumption that are efficient in the restricted sense that it would not be possible to
change the patterns in such a way so as to make some person better off without making
some other person worse off.
Economists recognize several commonly occurring circumstances of private choice,
referred to as market failures, that violate the basic assumptions of the idealized competi-
tive economy and, therefore, interfere with efficiency in production or consumption. The
traditional (or standard) market failures, which we discuss in Chapter 5, provide widely
accepted rationales for such public policies as the provision of goods and the regulation
of markets by government agencies. Economists, until recently, have paid less atten-
tion, however, to the plausibility and appropriateness of some of the more fundamental
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assumptions about the behavior of consumers. For example, economic models usually
treat the preferences of consumers as stable and basically unchanging. Is this reasonable?
Do consumers always make the right calculations when faced with decisions involving
such complexities as risk? Negative answers to any of these questions, which we consider
in Chapter 6, can also provide rationales for public policies.
Of course, efficiency is not the only social value. Human dignity, distributional equity,
economic opportunity, and political participation are values that deserve policy considera-
tion along with efficiency. On occasion, public decision makers or private individuals as
members of society may wish to give up some economic efficiency to protect human life,
make the final distribution of goods more equitable, or promote fairness in the distribu-
tion process. As analysts, we have a responsibility to address these multiple values and the

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 60 Problem Analysis
potential conflicts among them. We discuss distributional and other values as rationales
for public policies in Chapter 7.

The Efficiency Benchmark: The Competitive Economy

Imagine a world where each person derives utility (each person’s perception of their own
well-being) from personally consuming various quantities of all possible goods, including
things, services, and leisure. We can conceptualize each person as having a utility function
that converts the list of quantities of the goods consumed into a utility index such that
higher numbers imply greater well-being. This framing makes several basic assumptions.
First, other things equal, the more of any good a person has, the greater that person’s
utility. (We can incorporate unpleasant things such as pollution within this framework
by thinking of them as “goods” that decrease utility or result in disutility.) And, second,
additional units of the same good give ever-smaller increases in utility; in other words,
they result in declining marginal utility.
Analysis of the competitive model makes the following assumptions about the produc-
tion of goods: Firms attempt to maximize profits by buying factor inputs (such as labor,
land, capital, and materials) to produce goods for sale. The technology available to firms
for converting factor inputs to final goods is such that, at best, an additional unit of output
would require at least as many units of inputs to produce as the preceding unit; in other
words, it becomes more costly in terms of resources to produce each additional unit of the
good. Firms behave competitively in the sense that they believe that they cannot change
the prices of factor inputs or products by their individual actions.
Each person has a budget derived from selling labor and his or her initial endowments
of the other factor inputs (their wealth), such as capital and land. Individuals maximize
their well-being by using their incomes to purchase the combinations of goods that give
them the greatest utility.
In this simple and idealized world, a set of prices arises that distributes factor inputs
to firms and goods to persons in such a way that it would not be possible for anyone to
find a reallocation that would make at least one person better off without making at least
one person worse off.1 Economists refer to such a distribution as being Pareto efficient. It
is a concept with great intuitive appeal: wouldn’t, and shouldn’t, individuals and society
collectively be dissatisfied with an existing distribution if we could find an alternative
distribution that would make someone better off without making anyone else worse off?
Although we would need additional criteria for choosing between two distributions that
were each Pareto efficient, we should, unless we are malevolent, always want to make
Pareto-improving moves from inefficient distributions to efficient ones.
Figure 4.1 illustrates the concept of Pareto efficiency involving the allocation of $1,000
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between two people. Assume that the two people will receive any mutually agreed upon
amounts of money that sum to no more than $1,000. The vertical axis represents the
allocation to person 1 and the horizontal axis represents the allocation to person 2. An
allocation of all of the money to person 1 would appear as the point on the vertical axis
at $1,000; an allocation of all of the money to person 2 would appear as the point on
the horizontal axis at $1,000. The line connecting these two points, which we call the
potential Pareto frontier, represents all the possible allocations to the two persons that
sum exactly to $1,000. Any point on this line or inside the triangle it forms with the axes

1 For the history of general equilibrium theory, see E. Roy Weintraub, “On the Existence of a Competitive
Equilibrium: 1930–1954,” Journal of Economic Literature 21(1) 1983, 1–39.

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 Efficiency and the Competitive Model 61

$1,000

($800, $200)
Allocation to Person 1

Pareto Frontier

$100 ($100, $900)

$200 $1,000
Allocation to Person 2
Status quo: point ($100, $200)
Potential Pareto frontier: line segment connecting ($1,000, $0) and ($0, $1,000)
Pareto frontier: line segment connecting ($800, $200) and ($100, $900)

Figure 4.1 Pareto and Potential Pareto Efficiency

would be a technically feasible allocation because it gives shares that sum to no more than
$1,000.
The potential Pareto frontier indicates all the points that fully allocate the $1,000.
Any allocation that does not use up the entire $1,000 cannot be Pareto efficient, because
it would be possible to make one of the persons better off by giving her the remaining
amount without making the other person worse off. The actual Pareto frontier depends
on the allocations that the two people receive if they reach no agreement. If they each
receive nothing in the event they reach no agreement, then the potential Pareto frontier is
the actual Pareto frontier in that any point on it would make at least one of the persons
better off without making the other person worse off.
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Now suppose that, if these two people reach no agreement about an allocation, person 1
receives $100 and person 2 receives $200. This point ($100, $200) can be thought of
as the status quo point—it indicates how much each person gets in the absence of an
agreement. The introduction of the status quo point reduces the Pareto frontier to the
line segment between ($100, $900) and ($800, $200). Only moves to this segment of the
potential Pareto frontier would actually guarantee that each person is no worse off than
under the status quo.
Note that whether a particular point on the potential Pareto frontier is actually Pareto
efficient depends on the default allocations that comprise the status quo. More gener-
ally, Pareto efficiency in an economy depends on the initial endowments of resources to
individuals.

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 62 Problem Analysis
The idealized competitive economy is an example of a general equilibrium model—it
finds the prices of factor inputs and goods that clear all markets in the sense that the quan-
tity demanded exactly equals the quantity supplied. Although general equilibrium models
can sometimes be usefully applied to policy problems, limitations in data and problems of
tractability usually lead policy analysts to evaluate policies in one market at a time, that is,
with a partial equilibrium model.2 Fortunately, a well-developed body of theory enables
us to assess economic efficiency in the context of a single market.

Market Efficiency: The Meaning of Social Surplus

We need a yardstick for measuring changes in efficiency. Social surplus, which measures
the net benefits consumers and producers receive from participation in markets, serves
as that yardstick. In the context of the ideally competitive economy, the Pareto-efficient
allocation of goods also maximizes social surplus. When we look across markets, the set
of prices and quantities that give the greatest social surplus is usually Pareto efficient.
Moreover, differences in social surplus between alternative market allocations approxi-
mate the corresponding sum of differences in individual welfares. As social surplus is the
sum of consumer surplus and producer surplus, we consider each in turn.

Consumer Surplus: Demand Schedules as Marginal Valuations

Imagine that you have the last five tickets to the World Cup soccer final match. You
walk into a room and announce to those present that you own all the remaining tickets
to the event and that you will sell these tickets in the following manner: Starting with a
high stated price, say, $500, you will keep lowering it until someone agrees to purchase
a ticket. You will continue lowering the stated price until all five tickets are claimed. (An
auction such as this with declining prices is known as a Dutch auction; in contrast, an
auction with ascending prices is known as an English auction.) Each person in the room
decides the maximum amount that he or she is willing to pay for a ticket. If this maxi-
mum amount must be paid, then each person will be indifferent between buying and not
buying the ticket. Figure 4.2 displays the valuations for the persons in descending order
from left to right. Although the stated prices begin at $500, the first acceptance is at $200.
The purchaser obviously values this ticket at least at $200. Value in this context means
the maximum amount the person is willing to pay, given his or her budget and other
consumption opportunities. You now continue offering successively lower stated prices
until you sell a second ticket, which a second person accepts at $180, the second-highest
valuation. Repeating this process, you sell the remaining three tickets at $160, $140, and
$120, respectively.
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You were happy as a seller to get each person to pay the amount that he or she valued
the ticket. If, instead, you had set the price at $100 so that five people wanted to buy
tickets, then the purchasers would get tickets at a price substantially lower than the maxi-
mum amounts that they would have been willing to pay. For example, the person with the
highest valuation would have been willing to pay $200 but only has to pay your set price
of $100. The difference between the person’s dollar valuation of the ticket and the price

2 For a review of the use of general equilibrium models in education, see Thomas J. Nechyba, “What Can Be
(and What Has Been) Learned from General Equilibrium Simulation Models of School Finance?” National
Tax Journal 54(2) 2003, 387–414.

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 Efficiency and the Competitive Model 63

$200

$180

$160

$140

$120
Valuations

$100 +$80 +$60 +$40 +$20 = $300 surplus

$100

$50

1 2 3 4 5
World Cup Tickets

Figure 4.2 Consumer Values and Surpluses

that he or she actually pays ($200 minus $100) is the surplus value that the person gains
from the transaction. In a similar way, the person with the second-highest surplus gains
$80 ($180 minus $100). The remaining three purchasers receive surpluses of $60 ($160
minus $100), $40 ($140 minus $100), and $20 ($120 minus $100). Adding the surpluses
realized by these five purchasers yields a measure of the consumer surplus in this market
for World Cup final tickets of $300.
The staircase in Figure 4.2 is sometimes called a marginal valuation schedule because
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it indicates how much successive units of a good are valued by consumers in a market.
If, instead of seeing how much would be bid for successive units of the good, we stated
various prices and observed how many units would be purchased at each price, then we
would obtain the same staircase but recognize it as a demand schedule. Of course, we
would also get a demand schedule by allowing individuals to purchase more than one unit
at the stated prices. If we had been able to measure our good in small enough divisible
units, or if demanded quantities were very large, then the staircase would smooth out to
become a curve.
How do we move from this conceptualization of consumer surplus to its measurement
in actual markets? We make use of demand schedules, which can be estimated from
observing market behavior.

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 64 Problem Analysis
Line D in Figure 4.3 represents a person’s demand schedule for some good, X. (Later
we will interpret the curve as the demand schedule for all persons with access to the
market.) Note that this consumer values all units less than choke price, Pc , the price that
“chokes off” demand. The horizontal line drawn at P0 indicates that she can purchase as
many units of the good as she wishes at the constant price P0. At price P0 she purchases a
quantity Q0. Suppose, however, she purchased less than Q0; then she would find that she
could make herself better off by purchasing a little more because she would value addi-
tional consumption more than its cost to her. (The demand schedule lies above price for
quantities less than Q0.) Suppose, on the other hand, she purchased more than Q0, then
she would find that she could make herself better off by purchasing a little less because she
would value the savings more than the lost consumption. At given price P0, the quantity
Q0 is an equilibrium because the consumer does not want to move to an alternative quan-
tity. The area of the triangle under the demand schedule but above the price line, Pc a P0,
represents her consumer surplus from purchasing Q0 units of the good at price P0.
Changes in consumer surplus are often the basis for measuring the relative efficiencies
of alternative policies. For example, how does consumer surplus change in Figure 4.3 if a
government policy increases price from P0 to P1? The new consumer surplus is the area of
triangle Pc bP1, which is smaller than the area of triangle Pc aP0 by the area of the trapezoid
inscribed by P1baP0 (the shaded region). We interpret the area of the rectangle P1bcP0 as
the additional amount the consumer must pay for the units of the good that she continues

Pc
Price of X

b
P1

P0 a
c

D
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0 Q1 Q0
Quantity of X per Unit of Time
Loss in consumer surplus: P1baP0
Revenue collected by government: P1bcP0
Deadweight loss: abc

Figure 4.3 Changes in Consumer Surplus

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 Efficiency and the Competitive Model 65
to purchase and the area of the triangle abc as the surplus the consumer gives up by reduc-
ing consumption from Q0 to Q1.
As an example of a government policy that raises price, consider the imposition of an
excise (commodity) tax on each unit of the good in the amount of the difference between
P1 and P0. Then the area of rectangle P1bcP0 corresponds to the revenue raised by the
tax, which, conceivably, could be rebated to the consumer to offset exactly that part of
the consumer surplus lost. The consumer would still suffer the loss of the area of triangle
abc. Because there are no revenues or benefits to offset this reduction in consumer surplus,
economists define this loss in surplus due to a reduction in consumption as the deadweight
loss of the tax. The deadweight loss indicates that the equilibrium price and quantity
under the tax are not Pareto efficient—if it were possible, the consumer would be better
off simply giving the tax collector a lump-sum payment equal to the area of P1baP0 in
return for removal of the excise tax and its associated deadweight loss.
The loss of consumer surplus shown in Figure 4.3 approximates the most commonly
used theoretical measure of changes in individual welfare: compensating variation. The
compensating variation of a price change is the amount by which the consumer’s budget
would have to be changed so that he or she would have the same utility after the price
change as before. It thus serves as a dollar measure, or money metric, for changes in
welfare. If the demand schedule represented in Figure 4.3 is derived by observing how the
consumer varies purchases as a function of price, holding utility constant at its initial level
(it thus would be what we call a constant utility demand schedule), then the consumer
surplus change would exactly equal the compensating variation.
Figure 4.4 illustrates how compensating variation can be interpreted as a money metric,
or proxy, for utility. The vertical axis measures expenditures by a person on all goods
other than good X; the horizontal axis measures how many units of X she consumes.
Suppose initially that she has a budget, B, but that she is not allowed to purchase any units
of X, say, because X is manufactured in another country and imports of it are prohibited.
She will, therefore, spend all of B on other goods. The indifference curve I0 indicates all
the combinations of expenditures on other goods and units of X that would give her the
same utility as spending B on other goods and consuming no units of X. Now imagine
that the import ban is lifted so that she can purchase units of X at price Px. She can now
choose any point on the line connecting B with the point on the horizontal axis indicating
how many units of X she could purchase if she spent zero on other goods, B/Px. Once this
new budget line is available, she will maximize utility by selecting a point on the highest
feasible indifference I1, by purchasing x1 units of X and spending her remaining budget on
other goods. Once X is available, it would be possible to return her to her initial level of
utility by reducing her initial budget by the distance between B and C on the vertical axis.
This amount is the compensating variation associated with the availability of X at price
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Px. It is a dollar value, or money metric, for how much value she places on being able to
consume X.
Instead of asking how much money we could take away to make the person as well off
after introduction of imports of X as before, we could ask how much money we would
have to give her if X were not available, so that she is as well off as she would be with
imports of X. This amount, called equivalent variation, is shown as the distance between
A and B on the vertical axis—if her budget were increased from B to A, then she could
reach indifference curve I1 without consuming X.
In practice, we usually work with empirically estimated demand schedules that hold
constant consumers’ income (rather than utility) and all other prices. This constant
income, or Marshallian, demand schedule involves decreases in utility as price rises (and

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 66 Problem Analysis

line segment BC line segment AB

A

Equivalent
variation:
Money Spent on All Other Goods

B
Compensating
variation:

I1

I0

0 x1 B/Px
Quantity of Good X

Figure 4.4 Money Metrics for Utility

total consumption falls) and increases in utility as price falls (and total consumption
rises). In comparison with a demand schedule holding utility constant at the initial level,
the Marshallian demand schedule is lower for price increases and higher for price reduc-
tions. Fortunately, as long as either the price change is small or expenditures on the good
make up a small part of the consumer’s budget, the two schedules are close together and
estimates of consumer surplus changes using the Marshallian demand schedule are close
to the compensating variations.3
Now, moving from the individual to society, consider the relationship between price
and the quantity demanded by all consumers. We derive this market demand schedule by
summing the amounts demanded by each of the consumers at each price. Graphically, this
is equivalent to adding horizontally the demand schedules for all the individual consum-
ers. The consumer surplus we measure using this market demand schedule would just
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equal the sum of the consumer surpluses of all the individual consumers. It would answer
these questions: How much compensation would have to be given in aggregate to restore
all the consumers to their original utility levels after a price increase? How much could
be taken from consumers in the aggregate to restore them all to their original utility levels
after a price decrease?

3 In any event, the consumer surplus change measured under the Marshallian demand curve will lie between
compensating variation and equivalent variation. See Robert D. Willig, “Consumer Surplus without
Apology,” American Economic Review 66(4) 1976, 589–97. For a more intuitive justification of consumer
surplus, see Arnold C. Harberger, “Three Basic Postulates for Applied Welfare Economics,” Journal of
Economic Literature 9(3) 1971, 785–97.

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 Efficiency and the Competitive Model 67
Thus, if we can identify a change in price or quantity in a market that would produce
a net positive increase in social surplus, then there is at least the potential for making a
Pareto improvement. After everyone is compensated, there is still something left over to
make someone better off. Of course, the change is not actually Pareto improving unless
everyone is given at least his or her compensating variations from the surplus gain.
Our primary use of consumer surplus in Chapter 5 is to describe the inefficiencies associ-
ated with the various market failures. For this purpose, an exclusive focus on the potential
for Pareto improvement is adequate. In the context of cost–benefit analysis, the Kaldor–
Hicks compensation principle advocates a similar focus on net positive changes in social
surplus as an indication of the potential for Pareto improvements. When we consider cost–
benefit analysis as a tool for evaluating policies in Chapter 17, we discuss the implications
of focusing on potential rather than actual improvements in the welfare of individuals.

Producer Surplus: Background on Pricing

In the ideal competitive model, it is standard to assume that marginal cost of production for
each firm rises with increases in output beyond equilibrium levels. Because firms have some
fixed costs that must be paid before any production can occur, the average cost of produc-
ing output first falls as the fixed costs are spread over a larger number of units, then rises
as the increasing marginal cost begins to dominate, because the use of some input, such as
labor, becomes less efficient. Consequently, some output level minimizes the average cost
for the firm. The curve marked AC in Figure 4.5 represents a U-shaped average cost curve
for the firm. The marginal cost curve is labeled MC. Note that the marginal cost curve
crosses the average cost curve at the latter’s lowest point. When marginal cost is lower than
average cost, the latter must be falling. When marginal cost is higher than average cost,
Marginal Cost (MC), Average Cost (AC), and Price (P)

MC

PS a

AC
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AC S b

PL

0 QL QS
Output Level per Unit of Time

Figure 4.5 Average and Marginal Cost Curves

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 68 Problem Analysis
the latter must be rising. Only when marginal cost equals average cost does average cost
remain unchanged. This is easily grasped by thinking about your average score for a series
of examinations—only a new score above your current average raises your average.
The total cost of producing some level of output, say, QS, can be calculated in one
of two ways. First, because average cost is simply total cost divided by the quantity of
output, multiplying average cost at this quantity (ACS in Figure 4.5) by QS yields total
cost as given by the area of rectangle ACS bQS0. Second, recalling that marginal cost tells
us how much it costs to increase output by one additional unit, we can approximate total
cost by adding up the marginal costs of producing successive units from the first all the
way up to QS. The smaller our units of measure, the closer will be the sum of their associ-
ated marginal costs to the total cost of producing QS. In the limiting case of infinitesimally
small units, the area under the marginal cost curve (MC in Figure 4.5) from zero to QS
exactly equals total cost. (Those familiar with calculus will recognize marginal cost as
the derivative of total cost, so that integrating marginal cost over the output range yields
total cost; this integration is equivalent to taking the area under the marginal cost curve
between zero and the output level.)
Now suppose that the market price for the good produced by the firm is PS. The firm
would maximize its profits by producing QS, the quantity at which marginal cost equals
price. Because average cost is less than price at output level QS, the firm would enjoy a
profit equal to the area of rectangle PS abACS . Profit equals total revenue minus total cost.
(Total revenue equals price, PS, times quantity, QS, or the area of rectangle PS aQS0; the
total cost of producing output level QS is the area of rectangle ACS bQS0.) In the competi-
tive model, profit would be distributed to persons according to their initial endowments of
ownership. But these shares of profits would signal to other producers that profits could
be made simply by copying the firm’s current technology and inputs. As more firms enter
the industry, however, total output of the good would rise and, therefore, price would fall.
At the same time the new firms would bid up the price of inputs so that the entire marginal
and average cost curves of all the firms would shift up. Eventually, price would fall to PL,
the level at which the new marginal cost equals the new average cost. At PL profits fall to
zero, thus removing any incentive to enter the industry.
With no constraints on the number of identical firms that can arise to produce each
good, the Pareto-efficient equilibrium in the idealized competitive model is characterized
by zero profits for all firms. (Note that we are referring to economic profits, not account-
ing profits. Economic profit is total revenue minus payments at competitive market prices
to all factors of production, including an implicit rental price for capital owned by the
firm. Accounting profit is simply revenue minus expenditures.) If the firm does not make
an explicit payment to shareholders for the capital it uses, then accounting profits may be
greater than zero even when economic profits are zero. To avoid confusion, economists
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refer to economic profits as rents, which are defined as any payments in excess of the mini-
mum amounts needed to cover the cost of supply. Rents can occur in markets for inputs
such as land and capital as well as in product markets.
In the real economic world, unlike our ideal competitive model, firms cannot be instan-
taneously replicated; at any time some firms may thus enjoy rents. These rents, however,
attract new firms to the industry over time, so that over the long run we expect rents to
disappear. Only if some circumstance prevents the entry of new firms will the rents persist.
Therefore, we expect the dynamic process of profit seeking to move the economy toward
the competitive ideal.
To understand better the concept of rent, it is useful to contrast pricing in a monopolis-
tic industry with one that is competitive. To begin, consider the case of an industry with a

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 Efficiency and the Competitive Model 69
single firm that does not have to worry about future competition. This monopoly firm sees
the entire demand schedule for the good, labeled D in Figure 4.6. It also sees a marginal
revenue curve (MR), which indicates how much revenue increases for each additional
unit offered to the market. The marginal revenue curve lies below the demand schedule
because each additional unit offered lowers the equilibrium price not just for the last but
for all units sold. For example, imagine that increasing supply from 9 to 10 units decreases
the market price from $100/unit to $99/unit. Revenue increases by $90 (10 times $99
minus 9 times $100). The height of the marginal revenue curve above 10 units is thus $90,
which is less than the height of the demand schedule, $99. As long as marginal revenue
exceeds marginal cost (MC), the firm can increase profits by expanding output. The profit-
maximizing level of output occurs when marginal cost equals marginal revenue (where
MC intersects MR). In Figure 4.6, this output level for the monopoly firm, Qm, results in
a market price, Pm, and profits equal to the area of rectangle PmabACm: total revenue (Pm
times Qm) minus total cost (ACm times Qm).
In contrast to the case of monopoly, consider the production decisions of one of the
firms in a competitive industry. Because it provides a small part of the total industry

e
Average Cost (AC), Marginal Cost (MC),
Marginal Revenue (MR), and Price (D)

a MC
Pm

Pc c
AC

f
ACc
d
ACm
b
D
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0 Qm Qc
MR
Quantity/Time

Competitive pricing Monopoly pricing

Consumer surplus: Pcce Pmae
Total revenue: PccQc0 PmaQm0
Total cost: ACcdQc0 ACmbQm0
Rent: PccdACc PmabACm
Deadweight loss: 0 acf

Figure 4.6 Monopoly Pricing, Rents, and Deadweight Loss

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 70 Problem Analysis
supply, it ignores the effects of its supply on market price and, therefore, equates marginal
cost with price (the intersection of MC and D), yielding price PC and profits PCcdACC.
The difference in profit between monopoly and competitive pricing is the monopoly rent,
a type of economic rent.
Remembering that the profits of the firm go to persons, we should take account of these
rents in our consideration of economic efficiency. A dollar of consumer surplus (compen-
sating variation) is equivalent to a dollar of distributed economic profit. If we set the price
and quantity to maximize the sum of consumer surplus and rent, then we will generate the
largest possible dollar value in the market, creating the prerequisite for a Pareto-efficient
allocation.
The largest sum of consumer surplus and rent results when price equals marginal
cost. A comparison in Figure 4.6 of the sums of consumer surplus and rent between the
competitive and monopoly pricing cases illustrates this general proposition. The sum in
the monopoly case, where marginal cost equals marginal revenue (MC = MR), is the area
between the demand schedule and the marginal cost curve from quantity zero to Qm.
The sum in the competitive case, where marginal cost equals price (MC = P), is the area
between the demand schedule and the marginal cost curve from quantity zero to QC.
Obviously, the sum of consumer surplus and rent under competitive pricing exceeds that
under monopoly pricing by the shaded area between the demand schedule and the mar-
ginal cost curve from Qm to QC. This difference, the area of triangle acf, is the deadweight
loss caused by monopoly pricing. That this area is the deadweight loss follows directly
from the observation that the marginal benefit (vertical height of D) exceeds the marginal
cost (height of MC) for each unit produced in expanding output from Qm to QC.

Producer Surplus: Measurement with Supply Schedules

We usually deal with markets in which many firms offer supply. Therefore, we desire some
way of conveniently summing the rents that accrue to all the firms supplying the market.
Our approach parallels the one we used to estimate compensating variations. First, we
introduce the concept of a supply schedule. Second, we show how the supply schedule can
be used to measure the sum of rents to all firms supplying the market.
Imagine constructing a schedule indicating the number of units of a good that firms offer
at each of various prices. Figure 4.7 shows the common case of firms facing increasing
marginal costs. Firms offer a total quantity Q2 at price P2. As price increases, firms offer
successively greater quantities, yielding an upward-sloping supply schedule. The schedule
results from the horizontal summation of the marginal cost curves of the firms. (For exam-
ple, refer to MC in Figure 4.5.) Each point on the supply curve tells us how much it would
cost to produce another unit of the good. If we add up these marginal amounts one unit
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at a time, beginning with quantity equal to zero and ending at the quantity supplied, then
we arrive at the total cost of producing that quantity. Graphically, this total cost equals
the area under the supply curve from quantity zero to the quantity supplied.
Suppose the market price is P3 so that the quantity supplied is Q3. Then the total cost
of producing Q3 is the area P1aQ30. The total revenue to the firms, however, equals
price times quantity, given by the area of rectangle P3aQ30. The difference between total
revenue and total cost equals the total rent accruing to the firms. This difference is called
producer surplus. It is measured by the total shaded area in Figure 4.7 inscribed by P3aP1.
Producer surplus need not be divided equally among firms. Some firms may have
unique advantages that allow them to produce at lower cost than other firms, even
though all firms must sell at the same price. For instance, a fortunate farmer with very

Weimer, David, and Aidan Vining. Policy Analysis : Concepts and Practice, Taylor & Francis Group, 2017. ProQuest Ebook Central,
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 Efficiency and the Competitive Model 71

P3 a
Price

P2
b

P1

0 Q2 Q3
Quantity/Time
Loss in producer surplus resulting from a fall in price from P3 to P2: P3abP2

Figure 4.7 A Supply Schedule and Producer Surplus

productive land may be able to realize a rent at the market price, while another farmer
on marginal land just covers total cost. Because the quantity of very productive land is
limited, both farmers face rising marginal costs that they equate with market price to
determine output levels. The general point is that unique resources—such as especially
productive land, exceptional athletic talent, or easily extractable minerals—can earn
rents even in competitive markets. Excess payments to such unique resources are usually
referred to as scarcity rents. Unlike monopoly, scarcity rents do not necessarily imply
economic inefficiency.
Changes in producer surplus represent changes in rents. For example, if we want to
know the reduction in rents that would result from a fall in price from P3 to P2, then we
compute the change in producer surplus in the market. In Figure 4.7 the reduction in rents
equals the darker shaded area P3abP2, the reduction in producer surplus.
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Social Surplus
We now have the basic tools for analyzing efficiency in specific markets. A necessary
condition for Pareto efficiency is that it should not be possible to increase the sum of com-
pensating variations and rents through any reallocation of factor inputs or final products.
We have shown how changes in consumer surplus measure the sum of compensating
variations and how changes in producer surplus measure changes in rents. The sum of
consumer and producer surpluses in all markets is defined as social surplus. Changes in
social surplus, therefore, measure changes in the sums of compensating variations and
rents. For evaluating the efficiency implications of small changes in the price and quantity

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 72 Problem Analysis

P1 b
d

a
P0
Price

P2 e
c

Q1 Q0 Q2
Quantity/Time

Figure 4.8 Inefficiencies Resulting from Deviations from the Competitive Equilibrium

of any one good, it is usually reasonable to limit analysis to changes in social surplus in
its market alone.
Figure 4.8 reviews the inefficiencies associated with deviations from the equilibrium
price and quantity in a competitive market in terms of losses of social surplus. The efficient
competitive equilibrium occurs at price P0 and quantity Q0, the point of intersection of
the supply (S) and demand (D) schedules. A policy that reduces quantity to Q1 involves
a loss of social surplus given by the area of triangle abc—each forgone unit between Q1
and Q0 yields marginal value (as given by the height of the demand schedule) in excess of
marginal cost (as given by the height of the supply schedule). Consequently, social surplus
can be increased by changing policy so that the quantity supplied and demanded moves
closer to Q0. A policy that increases quantity to Q2 involves a loss of social surplus given
by the area of triangle ade—each additional unit supplied and demanded between Q0 and
Q2 yields marginal cost (as given by the height of the supply schedule) that is in excess of
marginal benefit (as given by the height of the demand schedule). Consequently, changing
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policy to move the quantity supplied and demanded closer to Q0 increases social surplus.

Caveats: Models and Reality

The general equilibrium model helps us understand a complex world. As is the case with
all models, however, it involves simplifications that may limit its usefulness. It is worth
noting three such limitations.
First, the general equilibrium model is static rather than dynamic. Real economies
constantly evolve with the introduction of new goods, improvement in technologies, and
changes in consumer tastes. An amazing feature of the price system is its capacity for
conveying information among decentralized producers and consumers about such changes,

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 Efficiency and the Competitive Model 73
4
which Friedrich Hayek refers to as “the particulars of time and place.” The equilibria of the
competitive framework give us snapshots rather than videos of the real world. Usually, the
snapshot is helpful and not too misleading. Nevertheless, policy analysts should realize that
substantial gains in social welfare result from innovations that were not, and perhaps could
not, have been anticipated. Policy analysts should be careful not to take too static a view of
markets. Large rents that seem well protected by barriers to entry, for example, may very
well spur innovative substitutes. In discussing each of the market failures in the next chap-
ter, we consider some of the market responses that may arise to reduce social welfare losses.
Second, the general equilibrium model can never be complete: modelers simply do
not have enough information to incorporate all goods and services. If they could, then
it would be unlikely they could solve the model for its equilibrium. Our switching from
the general equilibrium model to models of individual markets is a purposeful restriction
of the model so that it can be usefully applied. In most applications it is a reasonable
approach, though sometimes goods are such strong complements or substitutes that it is
not reasonable to look at them separately.5
Third, the assumptions of the general equilibrium model are often violated in the real
world. In the two chapters that follow, we consider the most important of these violations
of assumptions. We do so in the context of specific markets, acknowledging that doing so
may not fully capture all their implications in the wider economy.6 Nonetheless, we see
this analysis as highly valuable in helping policy analysts get started in understanding the
complexity of the world in which they work.

Conclusion
The idealized competitive economy provides a useful conceptual framework for thinking
about efficiency. The tools of applied welfare economics, consumer and producer surplus,
give us a way of investigating efficiency within specific markets. In the next chapter, we
explicate four situations, the traditional market failures, in which equilibrium market
behavior fails to maximize social surplus.

For Discussion
1. Assume that the world market for crude oil is competitive, with an upward-sloping
supply schedule and a downward-sloping demand schedule. Draw a diagram that
shows the equilibrium price and quantity. Now imagine that one of the major oil
exporting countries undergoes a revolution that shuts down its oil fields. Draw a new
supply schedule and show the loss in consumer surplus in the world oil market result-
ing from the loss of supply. What assumptions are you making about the demand for
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crude oil in your measurement of consumer surplus?

2. Now assume that the United States is a net importer of crude oil. Show the impact
of the price increase resulting from the loss of supply to the world market on social
surplus in the U.S. market.

4 F. A. Hayek, “The Use of Knowledge in Society,” American Economic Review 35(4) 1945, 519–30, at 522.
5 See Anthony E. Boardman, David H. Greenberg, Aidan R. Vining, and David L. Weimer, Cost–Benefit
Analysis: Concepts and Practice, 3rd ed. (Upper Saddle River, NJ: Pearson Prentice Hall, 2006), chapter 5.
6 R. G. Lipsey and Kelvin Lancaster, “General Theory of the Second Best,” Review of Economic Studies 24(1)
1956–1957, 11–32.

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