Equilibrium, allocative efficiency and total surplus

What we're going to do in this video is think about the market for chocolate, and we're going to think about supply and demand curves. But we're going to get an intuition for them in a slightly different way.

In particular, for the demand curve, we will think about the idea of marginal benefit. Now, marginal benefit, when we talk about margin, it's really thinking about what happens on the increment — what happens for each little extra that you do. So, this is saying, what is the benefit that I get if I get a little bit more of, in this case, chocolate?

Well, from the market's point of view, imagine if there was no chocolate, but there are people in the market who crave chocolate, who dream of chocolate. If all of a sudden they were able to get their hands on some chocolate, they would get a huge benefit from that incremental amount of chocolate. Maybe for these folks, their benefit, which we could quantify in terms of dollars, maybe their benefit is fifty dollars per pound. One way to think about it is they’d be willing to pay fifty dollars because they get that much benefit.

Or if they paid less than fifty dollars, let's say they paid ten dollars for it. Well, then they're getting forty dollars of extra benefit, of kind of surplus benefit from being able to get it at a price lower than their marginal benefit. But then, let's say, the more chocolate becomes available, people still like it, but some of that really deep need, that deep addiction for chocolate, has been satiated.

So, the marginal benefit tends to — in most markets, the marginal benefit tends to go down as quantity increases. One way to think about it is that first initial amount of quantity, if you — so we have some small amount of quantity right over here, I'll say delta quantity. That first quantity, if you multiply it times the marginal benefit, well, that gives you an area roughly of a rectangle like this.

It's not quite rectangular at the top; it's more of a trapezoid if this is downward sloping. But you could approximate it as a rectangle. But either way, the area right over here, the area under the marginal benefit curve, you could think about this as, well, what's just the benefit that the market is getting from consuming this chocolate in this case?

And so, let's just continue on this trend. If there's more and more chocolate, the market will get benefit from it, but people aren't as excited about it anymore. They're saying, "Oh, well, the chocolate's around, yeah, it'd be nice to have a little bit more, but I don't need so much more." And at some point, people might be all chocolated out, and they get maybe even zero marginal benefit from that incremental amount of chocolate.

Chocolate has filled up the town; there's nowhere to actually put it. Now, that won't always be the case; you might go someplace like that. But either way you think about it, we would view this as our marginal benefit curve.

Notice this is exactly the same as a demand curve in the market for chocolate. We have plotted price versus quantity in the market for chocolate, but we thought about it in terms of marginal benefit. Now, on the supply side, there's a related idea: we're going to think about marginal cost.

Marginal cost, so let's say at first there's no chocolate being produced in this market and a savvy entrepreneur says, "Hey, I know some folks who are addicted to chocolate; they would get a lot of benefit from it. So, I'm going to try to produce some chocolate." And they look around and they find out, "Hey, there's actually a derelict chocolate factory in town that no one is using, and it's surrounded by these wild cocoa bushes that are perfect for chocolate."

And there are some people in town who are actually unemployed, but they are amazing at producing chocolate. So, that the first units of chocolate, the marginal cost to produce it, is actually quite low. But once you utilize those folks, you utilize that derelict factory, utilize those free cocoa bushes or whatever, cocoa trees, well then you've got to plant new ones, you've got to train new employees, you've got to build a new factory.

And so, to produce that next increment, well that's going to cost a little bit more and then a little bit more and then a little bit more, which is the general trend in most markets. Initially, that first amount you produce in this cheaper way using the low-hanging fruit as possible. But then you've got to go up the tree, find higher and higher fruit. Maybe I'm mixing metaphors, but your cost — your marginal cost per unit goes higher and higher.

Now, what have we constructed here? Well, you might say, "Hey Sal, that's a marginal cost curve!" But once again, this also could be viewed as the supply curve for this particular market. Now, what is happening at these low quantities right over here? Well, the cost of production is — let's say they produce this delta q amount; the cost of production would be the area right over here under the marginal cost curve, that would be the cost of production.

But they're able to sell it. The benefit to the market, I should say, would be the total area under this red curve would be the benefit to the market, the total area under this curve. So, if you have the total benefit to the market, you take out the cost, then what you have in between these curves, you could view this as a surplus. You could view this as a surplus benefit right over here.

So, let me write this down. This is surplus. And you won't hear this term, but I like to use it because it makes it intuitive on what we're talking about. This is surplus benefit! So as long as there's surplus benefit, the suppliers are going to say, "Hey, wow! I can produce this cheaply; people have a — people get a lot of benefit for it." They'd be definitely willing to pay ten dollars a pound wherever I am.

If people are getting this much benefit, they're definitely going to be willing to pay ten dollars for it, so I'm going to produce some. Or actually, I'm going to produce some, and I could even charge — I could charge anywhere in between these areas. Maybe I could charge right over here, and I get some of the benefit, and then the consumers get some of the benefit. But then another maybe entrepreneur realizes, "Hey, well, there's more benefit to be had in this market."

So, they keep producing, they keep producing as long as there is benefit here. As long as the marginal benefit is higher than the marginal cost all the way until we get to that point right over here. Now, what happens? What happens right over here when we talk about just supply and demand? We talk about that's an efficient price and efficient quantity.

But let's just think about — we said up until this point it makes sense to produce more and more and more. Even this increment, if we're already at this quantity, it makes sense to produce even a little bit more because you're going to have this cost — you're going to incur this cost. But then the market could have all of this benefit. The market could have all of this benefit which is larger than the cost, so you say, "Well, as long as I sell it for something in between, we can split that surplus benefit, so to speak."

But once these two lines intersect and we have the situation where our marginal benefit — marginal benefit is equal to our marginal cost, well at that point, there is no surplus benefit now to be had. There's no really incentive to produce more than this. Beyond this point, your incremental cost of production — your marginal cost is higher than your marginal benefit. So, if you actually wanted to give it to someone for their benefit, you would be taking a loss.

Or even if you just think about the market itself, the society would be incurring more incremental cost per unit than they would be getting a benefit. So, why even do it? And so, this point right over here where these two lines — these two curves intersect, and we've talked about this with just supply and demand. But when we think about it in terms of marginal benefit and marginal cost, we think about this quantity right over here — let's just call it q sub zero.

This quantity is considered allocatively efficient — allocatively efficient, which is a very fancy word. Allocatively efficient. Why is that the case? Well, any other quantity would not be efficient. For example, let's say for some reason we were at this quantity right over here. Let's say q q 1. Well, what happens at this quantity right over here? Well, at this quantity, at this quantity right over here, the marginal benefit is higher than the marginal cost.

Marginal benefit is greater than the marginal cost, and so we're leaving a bunch of stuff on the table. The market is leaving a bunch of surplus benefit, you could say total surplus on the table. And so, this benefit that the market could have had but it does not get — this is called a deadweight loss. Deadweight loss! And we talk about it in other videos.

Remember, in the allocatively efficient quantity, we have this huge total surplus, which is the area under the marginal benefit curve and above the marginal cost curve up until the point of intersection. But if you do a quantity less than that allocatively efficient quantity, your marginal benefit is higher than your marginal cost, and you are leaving — you are leaving all of this total surplus on the table regardless of how you would have actually allocated it or distributed it between the consumers and the producers.

And what if you produced a quantity larger than the allocatively efficient quantity — once again, very fancy word? So let's say that's q2. What happens over here? Well, here you're able to take advantage of all of this surplus right over here — this total surplus right over here. But now you're creating negative surplus. So in this part, now all of this area shows a net — a net negative benefit or a net — I guess I would say a net cost that our market is incurring.

And so, this here — it was a deadweight loss because we were leaving stuff on the table that we could have had. Here, we're producing at a cost that our market — not just our suppliers are producing the cost, the benefit our market is getting is less for each incremental unit. It's less than — or is far less than the cost. And so, we are incurring a net negative total surplus.

And so this 2 would be considered — this 2 would be considered a dead — let me write that in a color you can see — a deadweight loss! Deadweight loss! We often assume it was — hey, we're leaving some total surplus on the table. But we also have deadweight loss in the case where we are producing unnecessarily because the benefit is less than the actual cost.

And so whether our marginal benefit is greater than our marginal cost or in this case, our marginal cost is greater than our marginal benefit, we are going to produce deadweight loss in either situation. A properly functioning market should be producing the quantity that is allocatively efficient in an ideal world. And of course, all of our models assume a lot of assumptions to make things a little bit cleaner so we can do lines to describe market behavior.