❔ Economic efficiency Questions and Answers

🙋 Do consumption externalities always only shift the demand curve? Do production externalities always shift the supply curve?

✔ Yes. The demand curve represents the net benefit that the consumer receives from the good from consuming the good. This means that the demand curve represents both the private benefits and the private costs of consumption.

demand = willingness to pay =
= private marginal benefits of consumption - private marginal costs of consumption

To calculate the marginal social benefits

By net benefit, we mean that consuming a good may have both costs and benefits. The total amount you are willing to pay for a good represents both of these. For example, when you purchase a hot dog at Fenway with extra onions, there are costs and benefits related to that consumption decision. If you are rational, you will take both of them into account. Your willingness to pay will reflect not only the benefits, but also the cost.
 Net benefits of consumption = benefits from consumption - costs of consumption.

The same will be true for other goods you consume. For example, there are costs to owning a home (taxes, maintenance, insurance, etc.), going skiing (injuries, travel time, time away from other activities), or consumption of alcohol.

🙋 Does economic efficiency maximize CS? Does it maximize PS?

✔ Economic efficiency maximizes TS, but that doesn’t mean that it necessarily maximizes either CS or PS.

For example, imagine a toy example in which you are the government and there are literally only three possible outcomes:

Option 1: CS = 10, PS = 0 (a bit like a price ceiling)
Option 2: CS = 0, PS = 10 (a bit like a price floor)
Option 3: CS = 8, PS = 8 (a bit like a free market)

Which would you choose? Remember, these are literally the only three options you have.

Note that Option 1 maximizes CS, Option 2 maximizes PS, and Option 3 maximizes TS.

Because Option 1 maximizes CS without maximizing TS, you could think of it like a binding price ceiling that lowers prices, assisting consumers at the expense of producers. While doing so, it decreases the total surplus in the system. Similarly, Option 2 is like a binding price floor that raises prices, assisting producers at the expense of consumers. While doing so, it decreases total surplus in the system.*↓

Option 3 is like a competitive market without any price controls. Option 3 is the only option that maximizes total surplus and is therefore the only one that is economically efficient. However, Option 3 doesn’t maximize either CS or PS.

Economic efficiency focuses on TS because $TS = CS + PS$ includes both CS and PS, weighing both equally. We weight CS and PS equally because we don’t have a scientific way to weigh whether we care more about CS or PS.

While this is a simple ‘toy example,’ it illustrates the point that economic efficiency doesn’t necessarily maximize either CS or PS even though it maximizes the sum of them.

* Note that price ceilings sometimes actually harm consumers because of the shortages, and price floors sometimes actually harm producers because there is insufficient demand. However, sometimes it looks more like this example, in which consumers are overall helped by a price ceiling or producers are overall helped by a price floor.