Total Surplus and Market Efficiency

Total surplus is the sum of consume surplus and producer surplus. When total surplus is maximized, market allocation is most efficient. Because consumer surplus = Price buyers willing to pay (value to buyers) - actual price and producer surplus = Actual price - price sellers willing to get (costs of sellers), total surplus = consumer surplus + producer surplus = Value to buyers - Costs of sellers. Costs of sellers must be minimized in order to maximize total surplus and market efficiency.

Two important aspects of market allocation are efficiency and equity. Efficiency is about how well resources are allocated and total surpluses maximized. For example, if goods are produced by sellers with relatively high costs, market allocation is not very efficient. But if the goods are produced by sellers with lowest costs, total surplus is maximized and efficiency achieved. Similarly, total surplus is maximized when goods are consumed by buyers who are most willing to buy or who value the goods the most rather than buyers who value the good less highly. Equity is about how well and how fairly the benefits of surpluses are divided between buyers and sellers.

In the graph of equilibrium, the total surplus is the area between between supply curve and demand curve from zero quantity to equilibrium quantity because consumer surplus is the area between equilibrium price level and demand curve while producer surplus is the area between equilibrium price level and supply curve.

Assuming markets are perfectly competitive (in real world, there might be a monopoly) and market outcome only affect buyers and sellers (in real world, they might affect bystanders by externalities or spillovers; ex. second hand smoke), there are three important points of market allocation. Firstly, efficient market allocates goods to consumers who value them the most. Secondly, efficient market allocates goods to producers who produce them with lowest costs. Thirdly, efficient market produce quantity of goods that maximize total surplus (not just consumer surplus or producer surplus).

Due to Point Number Three above, market is most efficient at equilibrium point because when quantity is less than equilibrium quantity, total surplus can be increased by producing more (value to buyers is still higher than costs of sellers); when quantity is more than equilibrium quantity, total surplus can be increased by producing less (value to buyers is lower than costs of sellers beyond equilibrium point).