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.