Efficiency and Markets II
Suppose that the government decides to help consumers by
lowering the price of bread with a subsidy to sellers. The
graph below indicates the effects of this policy. The
subsidy makes the price of bread look higher to sellers, and
they produce more. It makes the price look lower to buyers,
and they buy more. Because both buyers and sellers would
appear to be happy with this result, can we conclude that
this subsidy helps the economy? The answer is a surprising
The key to seeing why the subsidy does not increase value
is to realize what scarcity implies. The production of more
bread requires more resources, and these resources must be
drawn from other uses. To get the extra bread, consumers
must do with less of other goods.
In the simple model illustrated above, the value and cost
of the extra bread can be measured. The value of the extra
bread is the amount that people are willing to pay for it.
Consumers were not willing to buy the extra bread at the old
price, so it must be less valuable to them than the old
price. It will, in fact, be equal to the extra area under
the demand curve, or area b+c+d in graph above.
Production of this extra bread requires resources that
have more value than the value of the extra bread. Marginal
cost is the value that must be paid to resources in order to
produce one more loaf of bread, and this value exceeds the
value of the loaf with the subsidy. The extra cost will be
the area under the old supply curve, or area a+b+c+d.
The subsidy causes businesses to take valuable resources and
to transform them into less valuable output. There is a
waste in this process, and the triangular area a
measures this waste. Economists call this area welfare
Although bread subsidies are wasteful, they can be
politically popular. People see the good side of the
subsidy--the cheap bread. What they usually do not
understand is the bad side of the subsidy. They do not
realize that the higher prices of other goods can be related
to the low price of bread. An economic system is a
complicated system, and many of the cause-effect
relationships take a good deal of abstract thinking to
If a government subsidy increasing the amount of bread
does not help consumers, perhaps a contraction of the amount
of bread will. The discussion of consumers' and producers'
surpluses suggested that producers or consumers could gang
up on the other and transfer surplus. Suppose that bread
buyers unite and restrict purchases of bread. This union,
which changes our assumption of price taking, will force
down the price of bread.
The graph below illustrates the story of the consumers'
union. For the union to be successful, each buyer must
restrict purchases as Jane does in the graph. Consumers as a
whole will be better off as a result of this action because
consumers' surplus will rise. Prior to the union, consumers'
surplus will be a+e on the graph, but after the price
reduction, it will be a+c. As long as area c
is greater than area e, the consumers' union benefits
However, the union does not benefit society as a whole
because the Martha Smiths are as much members of society as
are the Jane Does. The consumers are better off only because
they have seized value that was already there, captured by
the producers. But in the process of making this transfer,
value equal to areas e+f was lost.
Furthermore, there are changes that could improve
consumer well-being. If consumers could continue to buy
Q1 at price P1, they would be willing to buy
additional loaves at a higher price. Another loaf has
greater value to them than the resources needed to make it.
If they could keep the low price of P1 for quantity
Q1 and then pay extra for additional loaves, they
could capture some of the wasted value. By restricting bread
production, resources have shifted from bread production to
other uses that are less valuable to society than the value
of foregone bread.
The unexploited value that the consumers' union creates
would be tempting for each individual, and it is unlikely
that such a union of many buyers could exist long because of
the free-rider effect. In practice the same result is
obtained by requiring the farmer to sell grain to the
government at a price below market equilibrium. The bread
price is kept low by a system of rationing, either by
queuing or coupon. Such systems are fairly common throughout
the world whenever bread consumers have more political
influence than peasants.
The two graphs above use a way of looking at economic
efficiency that helps some people understand the concept. A
situation is economically efficient when the sum of consumer
and producer surpluses is as large as possible. Because any
move that reduces that sum decreases value, it results in
Discussion of the welfare loss caused by bread subsidies
and by requirements that farmers sell their products to the
government at prices below world market prices is not just
of academic interest; such policies are widespread and
ancient. Rome had bread subsidies almost 2000 years ago.
More recently, various forms of bread subsidies and price
ceilings existed in the Soviet Union, some of the countries
of Eastern Europe, and parts of Africa. The price of bread
can be kept so low that governments must pass laws
prohibiting farmers from feeding their livestock bread
rather than grain, a temptation only when the price of bread
is less than the price of the grain used to make it.
This section has shown that it is fairly simple to
construct a model in which markets allocate resources in a
way that maximizes value. However, the reader should
understand that other results can occur with alternative
assumptions. Showing that markets in an imaginary world
result in economic efficiency does not tell us that markets
in the real world do, but only that they
1Not all changes in behavior
represent welfare loss. If a change makes John richer and
Joe poorer, Joe will consume less but his lower welfare may
be entirely offset by John's gain. Changes in behavior due
to changes in income are ignored in discussing welfare loss.
Only those changes that are substitution changes, in which a
person does more of one thing and less of another because of
changes in relative prices are counted as a welfare loss. As
a result, using regular demand curves to measure welfare
loss may result in an error. Instead, a special demand
curve, one that captures only substitution effects, is the
proper demand curve to use when drawing triangles of welfare
loss. In many cases, the difference will be very small, but
check an intermediate-level textbook under the topic of
"income-compensated demand curves" for more
2The conclusions of this
section can be shown more elegantly and precisely using
mathematical methods. But there is a cost to a mathematical
presentation--it requires sophisticated mathematics. The
previous discussion above tries to give the same insights in
a more intuitive manner.