KEY CONCEPTS AND SKILLS:
Ch. 2b – The Price Mechanism and Market Efficiency
Definitions:
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Productive Efficiency: when firms produce at the lowest possible cost
Allocative Efficiency: producing the combination of goods most wanted by society; it is achieved
when no one can become better off without making someone else worse off
Social (or community) surplus: the sum of consumer and producer surplus
o Consumer Surplus: the highest price consumers are willing to pay less the price actually
paid
o Producer Surplus; the price received by firms less the lowest price they are willing to
accept
Welfare: the amount of social surplus generated in a market (this is the microeconomics definition;
welfare more generally refers to the well-being of a nation)
Concepts and Applications:
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Ch. 2b
Outline how the concepts of scarcity and opportunity cost can help to explain how economies
choose what to produce.
Explain the function of prices in the allocation of resources.
Using a diagram, show how the signaling and incentive functions of prices can correct a shortage or
surplus.
How does allocative efficiency relate to the production possibilities frontier?
Identify consumer surplus and producer surplus on a supply and demand diagram.
Using a diagram, show how social surplus is maximized in a competitive market.
Explain why, if prices are so good at maximizing welfare (i.e., maximizing social surplus),
government intervention is sometimes needed.
Explain how allocative efficiency is related to the concepts of consumer surplus and producer
surplus.
Using the concepts of marginal benefit and marginal cost, explain how allocative efficiency is
achieved at competitive market equilibrium.