Allocative Efficiency

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(a) Explain how allocative efficiency is related to the concepts of consumer surplus and producer surplus.

Consumer surplus is defined as the highest price consumers are willing to pay for a good minus the price actually paid. As shown in the diagram, P1 is the highest price consumers are willing to pay for a good. Pe is the equilibrium price determined by the market. Any consumers are willing to pay price higher than Pe will end up paying Pe. This means they pay less than they expect, therefore, they gain benefit out of it which is the consumer surplus. On the diagram, the red area represents the consumer surplus.

Producer surplus is defined as the price received by firms for selling their good minus the lowers price that they are willing to accept to produce the good. P2 is the lowest price firms are willing to produce. Pe is the equilibrium price determined by the market. If the firms produce at any price between Pe and P2, they get benefits for producing with less cost than the equilibrium price. The extra benefit gained by firms is producer surplus which is the blue area in the diagram.

Allocative efficiency refers to produce the combination of goods mostly wanted by society. Consumer surplus and producer surplus determine what goods are wanted. The bigger the surplus, the more wanted the goods are. At the equilibrium point, the area of consumer surplus and producer surplus is the biggest which means the sum of consumer surplus and producer surplus is maximum. As a result, the good is most wanted at that point and allocative efficiency occurs at the equilibrium point of the market.

(b) Using the concepts of marginal benefit and marginal cost, explain how allocative efficiency is achieved at competitive market equilibrium.

Demand curve can be seen as the marginal benefit curve and the supply curve can be seen as the marginal cost curve. The market equilibrium occurs when MC=MB.

If the economy produces more than Qe, MC>MB, it will...
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