Short on time? This page is the recap. For explanations, graphs and worked examples, use the full study guide.
Recap
- Social efficiency (allocative efficiency): produce every unit whose marginal social benefit is at least its marginal social cost, and stop where MSB = MSC. Total economic surplus is then as large as it can be.
- A perfectly competitive market reaches this quantity when nobody outside the market is affected: demand = MPB = MSB, supply = MPC = MSC, and at equilibrium P = MB = MC.
- Rational agents equate private marginal benefit and private marginal cost. If private and social values differ, or if a firm can use market power, the market quantity is not efficient.
- Policymakers aim for MSB = MSC, but use cost-benefit analysis: a policy is worth it only if the surplus it restores is larger than its cost.
Key relationships
| Situation | Market quantity vs efficient quantity | Why |
|---|---|---|
| Perfect competition, no external effects | equal | P = MSB = MSC |
| Monopoly, oligopoly, monopolistic competition | too little | P > MC |
| Negative externality | too much | MSC > MPC is ignored |
| Positive externality | too little | MSB > MPB is ignored |
| Asymmetric information | usually too little | some worthwhile trades do not happen |
| Public goods | too little (often none) | free riding |
| Calculation | Rule |
|---|---|
| Efficient quantity (equations) | set MSB = MSC and solve for Q |
| Efficient quantity (table) | last unit with MSB ≥ MSC |
| DWL (table) | add MSB − MSC for every unit between Q and Q* (use the size) |
| DWL (straight lines) | ½ × (Q* − Q, as a size) × (MSB − MSC at Q, as a size) |
| Net gain of a policy | DWL removed − cost of the policy |
Assumptions
- MSB and MSC include everyone affected, not just the buyer and seller.
- Efficiency compares total surplus only; it ignores who receives it.
Mistakes to avoid
- Saying more output is always better: overproduction also creates DWL.
- Calling a monopoly’s extra profit a deadweight loss (it is a transfer).
- Using the MSB − MSC gap at one quantity as the DWL: DWL is an area.
- Forgetting the ½ in the triangle formula.
- Shading the DWL triangle on the wrong side: it always points to where MSB = MSC.
- Judging a policy only by the DWL it removes, without subtracting its cost.
Quick self-check
- MSB = 60 − Q and MSC = Q. What is the efficient quantity? (60 − Q = Q, so Q* = 30.)
- In question 1, a firm with market power produces 20. What is the DWL? (At 20, MSB = 40 and MSC = 20. DWL = ½ × 10 × 20 = 100.)
- Why can a competitive market be inefficient? (If buyers or sellers ignore costs or benefits that fall on others, private and social values differ.)
Next: practice questions.