A Primer on Macroeconomics, Volume I by Thomas M. Beveridge

Author:Thomas M. Beveridge
Language: eng
Format: epub
Publisher: Business Expert Press
Published: 2017-10-21T16:00:00+00:00

If, conversely, producers expand output beyond Q* there is also a deadweight loss. At Q2, for example, for the last item exchanged, the marginal benefit is less than the marginal cost. Such a unit should not be produced because there is a loss to society. Only units up to Q* should be produced. By expanding output to Q2, the market is reducing its total economic surplus. The benefit of the additional units beyond Q* is the area Q*ECQ2 but the additional cost is the area Q*EFQ2. The deadweight loss in this case is the area CFE.

This point is quite subtle and deserves additional comment. Recall that marginal cost is the opportunity cost of producing a unit of output and that opportunity cost, in turn, is “the value of the next most preferred alternative given up” when a choice is made. If we choose to produce an apple and use resources to produce it, then the opportunity cost of that apple is the value we place on the items we otherwise would have produced with those resources. We make an allocatively efficient choice if the value gained by producing the apple exceeds the value given up, but, if the value gained is less than the value given up, then the choice is allocatively inefficient and shouldn’t take place.

To maximize consumer surplus, buyers should buy until marginal benefit (MB) equals price (P) whereas, to maximize producer surplus, producers should produce until marginal cost (MC) equals price. Thus

MB = P = MC

To maximize total economic surplus and achieve allocative efficiency, the market should produce the quantity at which MB equals MC. If MB exceeds MC, then production should increase; if MB is less than MC, then production should decrease.

Left to its own devices, a free market does move to the situation where “demand equals supply” or, the same thing, “marginal benefit equals marginal cost.” Markets, then, are a powerful engine for maximizing allocative efficiency. We will return to this conclusion in Chapter 8 (in Volume II) when we look more closely at the benefits springing from international trade.

Review: This has been a long, arduous chapter dealing, as it does, with the primary analytical tool of economists—demand and supply. The single best piece of advice is “practice, practice, practice” and, with respect to diagrams, “draw, draw, draw.” The slippery distinction between a “change in quantity demanded” (caused by a change in price and shown as a movement along an existing demand curve) and a “change in demand” (caused by other factors and shown as a shift in the position of the demand curve) is controlled if a diagram is drawn. Like any tool, demand and supply analysis requires repeated practice before there is any sense of perfection but it is worth the effort because the tool is so generally applicable in the real world.

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