When the supply and demand curves for a product capture all the relevant costs and benefits of producing that product, then market equilibrium for that product will be efficient. In such a market, if price and quantity do not equal their equilibrium values, a transaction can be found that will make at least some people better off without harming others.
Total economic surplus is a measure of the amount by which participants in a market benefit by participating in it. It is the sum of total consumer surplus and total producer surplus in the market. One of the attractive properties of market equilibrium is that it maximizes the value of total economic surplus.
Efficiency should not be equated with social justice. If we believe that the distribution of income among people is unjust, we won’t like the results produced by the intersection of the supply and demand curves based on that income distribution, even though those results are efficient.
Even so, we should always strive for efficiency because it enables us to achieve all our other goals to the fullest possible extent. Whenever a market is out of equilibrium, the economic pie can be made larger. And with a larger pie, everyone can have a larger slice.
Regulations or policies that prevent markets from reaching equilibrium-such as price ceilings, price subsidies, and first-come, first-served allocation schemes-are often defended on the grounds that they help the poor. But such schemes reduce economic surplus, meaning that we can find alternatives under which both rich and poor would be better off. The main difficulty of the poor is that they have too little income. Rather than trying to control the prices of the goods they buy, we could do better by enacting policies that raise the incomes of the poor and then letting prices seek their equilibrium levels. Those who complain that the poor lack the political power to obtain such income transfers must explain why the poor have the power to impose regulations that are far more costly than income transfers.
Even when a good is provided by a public utility rather than a private firm, the theory of competitive supply has important implications for how to provide the good most efficiently. The general rule is that a public utility maximizes economic surplus by charging its customers the marginal cost of the goods it provides.
Critics often complain that taxes make the economy less efficient. A tax will indeed reduce economic surplus if the supply and demand curves in the market for the taxed good reflect all the relevant costs and benefits of its production and consumption. But this decline in surplus may be more than offset by the increase in economic surplus made possible by public goods financed with the proceeds of the tax. The best taxes are imposed on activities that would otherwise be pursued to excess, such as activities that generate environmental pollution. Such taxes not only do not reduce economic surplus; they actually increase it.
