4.2 Total Surplus and Market Efficiency
The total surplus in a market — equal to the sum of consumer surplus and producer surplus — represents a measure of the overall welfare generated by trade. In this section, we will examine how, under perfect competition, the market mechanism leads to an efficient allocation of resources, that is, to the maximization of total surplus. In later chapters, we will explore situations in which obstacles to contracting — such as market power, externalities, or informational asymmetries — can result in suboptimal levels of social welfare.
Total Surplus in the Short Run
In a short-run competitive equilibrium, total surplus is maximized given the existing technological resources, that is, considering that the number of firms — and hence the number of production units — is fixed. There is no alternative quantity produced and consumed, nor any different allocation of the equilibrium quantity among the existing firms, that would increase total surplus.
The following figure, based on the data from Figure 4.3, illustrates the first property: there is no quantity produced and consumed, other than the equilibrium quantity, that generates a total surplus greater than that at equilibrium.
The following figure, also based on the data from Figure 4.3, illustrates the second property: there is no allocation of production among the firms in the market, other than the equilibrium one, that generates a total surplus greater than that at equilibrium. The socially efficient allocation of production is for all firms to produce the same quantity.
Total Surplus in the Long Run
In the long run, the previously mentioned constraint — namely, the fixed number of firms — no longer applies: firms are free to enter or exit the market. The number of firms is not fixed but is instead determined by the equilibrium itself. In this context, total surplus is again maximized and, when fixed costs are taken into account, even higher than in the short run.
The key difference is that each firm operates in the least costly way possible, producing exactly at the efficient output level, $Q^{\text{eff}}$, which minimizes average cost. This results in an additional form of social efficiency: not only are the total quantity produced and its distribution among firms optimal, but the number of firms in the market is also efficient. It corresponds exactly to the number needed to meet demand at the lowest possible cost to society.
Another crucial difference from the short run concerns the distribution of the surplus generated. In the long-run equilibrium, competition and the possibility of entry and exit completely erode firms’ profits: each firm earns zero profit (or, in other words, zero producer surplus). As a result, the entire surplus generated by the market accrues exclusively to consumers. Consumer surplus is equal to total surplus: consumers fully appropriate the social value created by exchange.