9781118041581

Market Efficiency 301

Figure 7.7, because day-care suppliers earn zero profits: Price equals average

cost. All gain takes the form of consumer surplus. It is easy to check that the

total surplus measures out to (.5)(12 2.5)(9.5) $45.125 million.

An equivalent way to confirm that the competitive level of output is effi-

cient is to appeal to the logic of marginal benefits and costs. We have argued

that the height of the demand curve at a given output level, Q, measures the

marginal benefit (in dollar terms) of consuming the last (Qth) unit. Similarly,

the height of the supply curve indicates the marginal cost of producing the

Qth unit. At a competitive equilibrium, demand equals supply. A direct conse-

quence is that marginal benefit equals marginal cost. Equating marginal ben-

efits and marginal costs ensures that the industry supplies the “right” quantity

of the good—the precise output that maximizes the total net benefits (con-

sumer benefits minus supplier costs) from production.

In contrast, at a noncompetitive price—say $4—only 8 million day-care hours

would be demanded. At this reduced output, the marginal benefit (what con-

sumers are willing to pay for additional day-care hours) is $4, and this is greater

than the marginal cost of supplying extra hours, $2.50. Thus, there is a net wel-

fare gain of 4.00 2.50 $1.50 for each additional day-care hour supplied. More

generally, as long as the demand curve lies above the supply curve (MB MC),

there is a net gain (MB MC 0) from increasing the output of day care.

Conversely, at any output level beyond the competitive quantity (say, 11 million

hours), the marginal benefit of extra hours falls short of the marginal cost of

supply (MB MC). Producing these units is a “losing” proposition. Thus, there

is a net gain from cutting output back to the competitive level.^12

Figure 7.7 provides a visual depiction of our original proposition:

Competitive markets provide efficient levels of goods and services at minimum cost

to the consumers who are most willing (and able) to pay for them.

Think of this statement in three parts, focusing on production, consumption,

and total output in turn. First, in a competitive market, the active firms are

(^12) In mathematical terms, consider the objective of maximizing the sum of consumer surplus and
producer profit:
where B denotes the total consumer benefits associated with a given level of output, R is total rev-
enue paid by consumers to producers, and C is the total cost of production. The revenue term is
simply a transfer between consumers and producers and does not affect the objective. Thus, max-
imizing this sum is equivalent to maximizing net benefits, B C. At the optimal level of output, it
must be the case that MB MC.
Furthermore, the competitive equilibrium achieves this optimal level of output. To see this,
consider the demand and supply curves, denoted by the functions D(Q) and S(Q), respectively.
The competitive price and output are determined by the intersection of supply and demand,
D(QC) S(QC) PC. By our earlier argument, D(Q) ≡MB(Q) and S(Q) ≡MC(Q) for all Q,
where MB and MC denote the marginal benefit and cost functions, respectively. It follows that
MB(QC) MC(QC) Pc. Thus, the competitive level of output is efficient.
SurplusProfit(BR)(RC)BC,
c07PerfectCompetition.qxd 9/29/11 1:30 PM Page 301