2023 Prelim SL P1 Ans Collated

Suggested answers for SL P1 Q1 (a) Explain that when producer surplus and consumer surplus are maximised, allocative efficiency is achieved. [10] Answers may include:  Definitions of consumer surplus, producer surplus, allocative efficiency  Diagram (demand and supply) to show producer and consumer surplus and allocative efficiency  An explanation that consumer surplus is the difference between the price the consumer is willing and able to pay for a good and its selling price; an explanation that the producer surplus for a good is the difference between the price the producer is willing and able to sell the good for and its selling price; an explanation that the sum of consumer and producer surplus is maximised in competitive market equilibrium and allocative efficiency is achieved Consumer surplus is defined as the highest price consumers are willing and able to pay for a good minus the price actually paid. The highest price they are willing and able to pay is given by the demand curve. Producer surplus is defined as the price actually received by producers for selling their good minus the price that they are willing and able to accept. The lowest price they are willing and able to accept is shown by the supply curve. The price actually paid and received by the consumers and producers is determined at the market equilibrium via demand and supply forces. Allocative efficiency is achieved when scarce resources are allocated to produce the right amount of right goods desired by the society. In a competitive market, this is achieved when the social surplus (i.e. the sum of producer surplus and consumer surplus) is maximised. The demand curve also depicts the marginal benefit as the extra benefit derived from consuming an additional unit of the good decreases as the quantity increases (hence, the

price consumers are willing and able to pay for every subsequent unit falls according to the law of demand). The supply curve also depicts the marginal cost as the extra cost incurred from producing an additional unit of the good increases as the quantity increase (hence, to cover the rising cost, the price producers are willing and able to accept for every subsequent unit must increase in accordance with the law of supply). The competitive market equilibrium occurs at E, where the demand (DD=MB) and supply (SS=MC) curves intersect. This is the point where the extra benefit to society of consuming an additional unit of the good equals to the extra cost to society of producing an additional unit of the good. At this point where Qe units of the good transacted in the market, the sum of consumer surplus (AEPe) and producer surplus (0EPe) is maximised. Allocative efficiency is achieved. If Qa units are transacted instead, consumer surplus area will be lower at PeABC and producer surplus area will be lower at 0PeCD. This results in a welfare loss to society of area BDE. Since MB>MC fo