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Not only does a free market eliminate surpluses and shortages, a free market allocates<br />

production to the lowest cost producers and allocates consumption to the buyers who value the<br />

goods most highly. The producers willing to produce at the market price are the ones whose cost<br />

of production is equal to or less than the market price. The consumers who are willing to buy at<br />

the market price are the ones who value the goods as much as or more than the market price<br />

Free Markets and Economic Efficiency I<br />

A free market generally results in the most efficient quantity of output. We saw in Chapter 1 that<br />

any activity should be continued as long as the marginal benefit of the activity exceeds the<br />

marginal cost. The optimal (ideal, most efficient) level of the activity occurs where the marginal<br />

benefit and the marginal cost are equal.<br />

In a competitive product market, the marginal benefit of the product is indicated by the price that<br />

the marginal consumer is willing to pay. The price that the marginal consumer is willing to pay is<br />

indicated by the demand curve. The marginal cost of producing the product is indicated by the<br />

supply curve. Where the demand curve and the supply curve intersect (equilibrium) is the quantity<br />

where the marginal benefit of the product equals the marginal cost of the product. Thus, a free<br />

market generally produces the optimal (ideal, most efficient) quantity of output.<br />

Free Markets and Economic Efficiency II<br />

We saw in Chapter 2 that the net benefit to society of having a market available for trading is the<br />

sum of the consumer’s surplus and the producer’s surplus received by all the buyers and sellers<br />

in the market. Consumer’s surplus is the difference between the highest price a buyer is willing to<br />

pay and the price actually paid. For all the buyers in a market, consumer’s surplus is indicated by<br />

the area below the demand curve and above the market price. Producer’s surplus is the<br />

difference between the lowest price a seller is willing to accept and the price actually received.<br />

For all the sellers in a market, producer’s surplus is indicated by the area above the supply curve<br />

and below the market price.<br />

In a free market, the quantity produced (equilibrium quantity) is the quantity that maximizes the<br />

net benefit to society of having the market available for trading (i.e. maximizes the sum of the<br />

consumer’s surplus and the producer’s surplus received by all the buyers and sellers in the<br />

market).<br />

Example 12: The graph below indicates the consumer’s surplus and the producer’s surplus in the<br />

market for Good X (from Example 11).<br />

$7 -<br />

S<br />

6 -<br />

Consumer’s<br />

5 -<br />

Surplus<br />

Price 4 -<br />

Producer’s<br />

3 -<br />

Surplus<br />

2 -<br />

1 -<br />

0 <br />

D<br />

<br />

0 5 10 15 20 25 30 35 40<br />

FOR REVIEW ONLY - NOT FOR DISTRIBUTION<br />

Quantity<br />

3 - 7 Demand, Supply, and Equilibrium

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