AP® Microeconomics review sheet from Aim for Five (aimforfive.com/micro/units/6/6-1)
Unit 6 · Topic 6.1
6.1 Socially Efficient and Inefficient Market Outcomes
An outcome is socially efficient when the last unit produced is worth exactly what it costs society to make: marginal social benefit equals marginal social cost. That's where total surplus is as large as it can be. This topic explains how to spot an inefficient outcome, measure its deadweight loss, and name the main reasons markets miss the efficient quantity.
Key terms
- allocative efficiency
- marginal social benefit (MSB)
- marginal social cost (MSC)
- total surplus
- deadweight loss
- asymmetric information
Social benefit, social cost and efficiency
Marginal social benefit (MSB) is the extra benefit to everyone in society from one more unit: the buyer's benefit plus any benefit to other people. Marginal social cost (MSC) is the extra cost to everyone: the seller's cost plus any cost pushed onto other people.
The socially efficient (allocatively efficient) quantity is where MSB = MSC. Below it, one more unit is worth more to society than it costs, so making it adds to total surplus. Above it, the last units cost society more than they're worth, so making them subtracts from total surplus. Only at MSB = MSC is total surplus (consumer surplus + producer surplus + any effect on outsiders) as large as possible.
When markets get it right, and deadweight loss
In a perfectly competitive market where buyers and sellers bear all the benefits and costs, the demand curve measures MSB and the supply curve measures MSC. So the market equilibrium is the efficient quantity. That's the result you met in 2.6.
Deadweight loss is the total surplus lost when output isn't at the efficient quantity. On a graph with price on the vertical axis and quantity on the horizontal, it's a triangle between the MSB and MSC curves. Its point is at the efficient quantity, where the curves cross, and its base is the vertical gap between the curves at the quantity actually produced.
Underproduction and overproduction both create deadweight loss. Underproduction loses trades that were worth making. Overproduction makes units that are worth less than they cost.
Why markets can fail
A market failure is when a market, left alone, doesn't produce the efficient quantity. The main causes in this course:
- Market power: monopolies and other firms with market power keep price above marginal cost and produce too little (4.2).
- Externalities: costs or benefits that land on people outside the deal (6.2).
- Public goods: goods people can use without paying, so markets underprovide them (6.3).
- Asymmetric information: one side of a deal knows something important that the other side doesn't.
Asymmetric information
When a seller knows much more about quality than the buyer, buyers worry about getting a bad deal, so they won't pay full price even for good products. Sellers of good products may then leave the market. The classic example is used cars: the seller knows if the car is a 'lemon' and the buyer doesn't. This is called adverse selection.
The information gap can run the other way too. A person buying health insurance knows more about their own health than the insurer does. And once people are insured, they may take more risks because they don't bear the full cost, which is called moral hazard.
Fixes include warranties, inspections, licensing, honest-disclosure laws and reviews from other buyers. They all work by closing the information gap. You don't need the terms adverse selection and moral hazard for the exam; what matters is explaining how an information gap leads to fewer (or worse) trades than is efficient.
Efficient isn't the same as fair
Efficiency is about the size of total surplus, not how it's split. An outcome can be efficient but very unequal. Questions about fairness are about equity, and that's where inequality (6.5) comes in.
Worked examples
Try each one yourself first, then open the solution.
- Example 1
Finding the efficient quantity and deadweight loss from a table
For a good, the marginal social benefit of units 1 through 6 is $50, $40, $30, $20, $10 and $0. The marginal social cost of units 1 through 6 is $10, $15, $20, $25, $30 and $35. (a) What is the socially efficient quantity? (b) If the market produces 5 units, what is the deadweight loss? (c) If it produces only 2 units, what is the deadweight loss?
Show the solutionHide the solution
- Step 1: (a) Produce each unit whose MSB is at least its MSC. Unit 1: 50 > 10. Unit 2: 40 > 15. Unit 3: 30 > 20. Unit 4: 20 < 25, so stop. The efficient quantity is 3.
- Step 2: (b) Units 4 and 5 shouldn't be made. Each one destroys surplus equal to MSC − MSB: unit 4, 25 − 20 = $5; unit 5, 30 − 10 = $20. Deadweight loss = 5 + 20 = $25.
- Step 3: (c) Unit 3 isn't made, but it was worth making. The surplus lost is MSB − MSC = 30 − 20 = $10.
Answer: (a) 3 units. (b) $25. (c) $10.
- Example 2
Explaining an information problem
In a used-phone market, sellers know whether their phone has a hidden battery problem, but buyers can't tell. Explain why this market may produce fewer trades than is efficient, and name one way to fix it.
Show the solutionHide the solution
- Step 1: Name the cause: this is asymmetric information. Sellers know the quality; buyers don't.
- Step 2: Show the effect on buyers: since any phone might be bad, buyers will only pay a price that reflects average quality.
- Step 3: Show the effect on sellers: owners of good phones get less than their phones are worth, so many don't sell. The phones left for sale are more likely to be bad, which pushes buyers' offers down further.
- Step 4: Conclude: trades that would benefit both sides (good phones sold for what they're worth) don't happen, so output is below the efficient quantity.
- Step 5: Fix: a warranty, an independent battery test or a store's certified-used program gives buyers the missing information.
Answer: Asymmetric information makes buyers pay only for average quality, so sellers of good phones leave and beneficial trades are lost. Warranties or independent testing can fix it.
Common mistakes
- Thinking that producing more is always better. Units past the efficient quantity cost more than they're worth and create deadweight loss.
- Saying a market is efficient because it's in equilibrium. Equilibrium is efficient only when supply reflects all social costs and demand reflects all social benefits.
- Mixing up efficiency and equity. An efficient outcome can still be unfair, and a fairer one can be less efficient.
- Placing the deadweight loss triangle on the wrong side of the efficient quantity. It always lies between the efficient quantity and the quantity actually produced.
On the exam
- Questions often ask whether a given quantity is efficient and why. Answer with the comparison: 'At this quantity, MSB is greater than MSC, so output is too low' (or the reverse).
- Be ready to identify deadweight loss on a described graph or from a table, and to name which market failure is causing it.
Connected topics
Videos
Check yourself
4 questions on 6.1 Socially Efficient and Inefficient Market Outcomes. Pick an answer to see if you got it, and why.
A market outcome is socially efficient when the quantity produced is where
In a perfectly competitive market with no externalities, the socially efficient quantity is
A seller of used cars knows which of her cars have hidden engine problems, but buyers can't tell the good cars from the bad ones. This situation is an example of
Which of the following is a source of market failure?
0 of 4 answered