Equilibrium and welfare

Economic welfare, as measured by consumer and producer surplus, is maximised at market equilibrium price and quantity. Assuming their are no consumption or production externalities, market equilibrium price and quantity can be shown to be efficient in terms of generating maximum economic welfare.

At equilibrium, consumer surplus is maximised at area X A P, and producer surplus is maximised at P A K.

Loss of welfare at non-equilibrium prices

Higher prices

A non-equilibrium price, at P1, causes demand to contract and consumer surplus to shrink while producer surplus increases. However, there is a net welfare loss of area: B, A, C.

Lower prices

At a lower price, at P2, supply contracts, so that output is at Q1. Producer surplus shrinks, but consumer surplus increases. However, the net effect is for welfare to fall by area: B, A, C.

In conclusion, any divergence from equilibrium price will result in a welfare loss. Here, markets will work effectively to eliminate non-equilibrium prices. The free operation of the price mechanism will mean that markets are constantly adjusting to establish equilibrium, with price changes acting as signals to both consumers and producers to adjust their demand or supply.

An increase in demand raises welfare

An increase in demand raises both consumer and producer surplus. An increase in demand will raise the market price and increase output, withe the result that consumer and producer surplus increase.

Lower demand lowers welfare

A decrease in demand will reduce the market price and reduce output resulting in a fall in both consumer and producer surplus.

Increases in supply increase welfare

An increase in supply will reduce the market price and increase output, resulting in an increase in consumer and producer surplus.

Decreases in supply reduce welfare

Conversely, a decrease in supply will increase the market price and reduce output - both consumer and producer surplus fall.