12.8 : Supply and Demand, and Efficiency in a Perfectly Competitive Market II

In a perfectly competitive market, efficiency is assumed to be achieved by maximizing total surplus, which is the sum of consumer and producer surplus, as visible on the graph. 

The market supply curve represents the marginal cost curve of all firms participating in the market. Suppose the supply is expanded to Q2. However, the marginal cost rises with higher production. 

Consequently, the market price would rise to P2. The perfectly competitive market model assumes that producers will increase output until their marginal cost is equal to the prevailing market price. 

When the market price is above equilibrium, sellers produce more quantity than is demanded by consumers at that price. This leads to surplus inventories placing downward pressure on the offering price of suppliers. 

This price decrease encourages greater quantity demanded by consumers, and the market is moved towards the equilibrium price and quantity that maximizes producer and consumer surplus.

So, a quantity greater than the market equilibrium or less than the market equilibrium results in deadweight loss. 

It follows that total surplus is maximized at equilibrium, where supply equals demand.