3.12. Markets Maximize Society’s Total Surplus

Recall that the market demand curve can be considered the willingness of consumers to pay for each additional unit of a good. Hence, it is society’s marginal value curve for that good. Additionally, the market supply curve represents the marginal cost to society to produce each additional unit of that good, assuming no positive or negative externalities. (An externality is a case in which production costs or the consumption benefits of a good or service spill over onto those who are not producing or consuming the good or service; a spillover cost (e.g., pollution) is called a negative externality, a spillover benefit (e.g., literacy programs) is called a positive externality.)

At equilibrium, where demand and supply curves intersect, the highest price that someone is willing to pay is just equal to the lowest price that a seller is willing to accept, which is the marginal cost of that unit of the good. In Exhibit 14, that equilibrium quantity is Q₁. Now, suppose that some influence on the market caused less than Q₁ units to be traded, say only Q′ units. Note that the marginal value of the Q′th unit exceeds society’s marginal cost to produce it. In a fundamental sense, we could say that society should produce and consume it, as well as the next, and the next, all the way up to Q₁. Or suppose that some influence caused more than Q₁ to be produced, say Q′′ units. Then what can we say? For all those units beyond Q₁, and up to Q′′, society incurred greater cost than the value it received from consuming them. We could say that society should not have produced and consumed those additional units. Total surplus was reduced by those additional units because they cost more in the form of resources than the value they provided for society when they were consumed.

There is reason to believe that markets usually trend toward equilibrium and that the condition of equilibrium itself is also optimal in a welfare sense. To delve a little more deeply, consider two consumers, Helen Smith and Tom Warren, who have access to a market for some good, perhaps gasoline or shoes or any other consumption good. We could depict their situations using their individual demand curves juxtaposed on an exhibit of the overall market equilibrium, as in Exhibit 15 where Smith’s and Warren’s individual demands for a particular good are depicted along with the market demand and supply of that same good. (The horizontal axes are scaled differently because the market quantity is so much greater than either consumer’s quantity, but the price axes are identical.)

At the market price of P∗x , Smith chooses to purchase Q_H, and Warren chooses to purchase Q_T because at that price, the marginal value for each of the two consumers is just equal to the price they have to pay per unit. Now, suppose someone removed one unit of the good from Smith and presented it to Warren. In Panel A of Exhibit 15, the loss of value experienced by Smith is depicted by the dotted trapezoid, and in Panel B of Exhibit 15, the gain in value experienced by Warren is depicted by the crosshatched trapezoid. Note that the increase in Warren’s value is necessarily less than the loss in Smith’s. Recall that consumer surplus is value minus expenditure. Total consumer surplus is reduced when individuals consume quantities that do not yield equal marginal value to each one. Conversely, when all consumers face the identical price, they will purchase quantities that equate their marginal values across all consumers. Importantly, that behavior maximizes total consumer surplus.

A precisely analogous argument can be made to show that when all producers produce quantities such that their marginal costs are equated across all firms, total producer surplus is maximized. The result of this analysis is that when all consumers face the same market equilibrium price and are allowed to buy all they desire at that price, and when all firms face that same price and are allowed to sell as much as they want at that price, the total of consumer and producer surplus (total surplus) is maximized from that market. This result is the beauty of free markets: They maximize society’s net benefit from production and consumption of goods and services.