Efficiency in perfectly competitive markets

Posted 2023-02-15 11:44:02

Key points

Long-run equilibrium in perfectly competitive markets meets two important conditions: allocative efficiency and productive efficiency.
These two conditions have important implications. First, resources are allocated to their best alternative use. Second, they provide the maximum satisfaction attainable by society.

Efficiency in perfectly competitive markets

When profit-maximizing firms in perfectly competitive markets combine with utility-maximizing consumers, something remarkable happens—the resulting quantities of outputs of goods and services demonstrate both productive and allocative efficiency.

Productive efficiency means producing without waste so that the choice is on the production possibility frontier. In the long run in a perfectly competitive market—because of the process of entry and exit—the price in the market is equal to the minimum of the long-run average cost curve. In other words, goods are being produced and sold at the lowest possible average cost.

Allocative efficiency means that among the points on the production possibility frontier, the point that is chosen is socially preferred—at least in a particular and specific sense. In a perfectly competitive market, price is equal to the marginal cost of production. Think about the price that is paid for a good as a measure of the social benefit received for that good; after all, willingness to pay conveys what the good is worth to a buyer. Then think about the marginal cost of producing the good as representing not just the cost for the firm but, more broadly, as the social cost of producing that good.

When perfectly competitive firms follow the rule that profits are maximized by producing at the quantity where price is equal to marginal cost, they are ensuring that the social benefits received from producing a good are in line with the social costs of production.

Let's walk through an example to more thoroughly explore what is meant by allocative efficiency. Let's begin by assuming that the market for wholesale flowers is perfectly competitive, so start text, P, end text, equals, start text, M, C, end text. Now, consider what it would mean if firms in that market produced a lesser quantity of flowers. At a lesser quantity, marginal costs would not yet have increased as much, so the price would exceed marginal cost: start text, P, end text, is greater than, start text, M, C, end text.

In this situation, the benefit to society as a whole of producing additional goods—as measured by the willingness of consumers to pay for marginal units of a good—would be higher than the cost of the inputs of labor and physical capital needed to produce the marginal good. In other words, the gains to society as a whole from producing additional marginal units would be greater than the costs.

On the other hand, consider what it would mean if—compared to the level of output at the allocatively efficient choice where start text, P, end text, equals, start text, M, C, end text—firms produced a greater quantity of flowers. At a greater quantity, marginal costs of production would increase so that start text, P, end text, is less than, start text, M, C, end text. In this case, the marginal costs of producing additional flowers would be greater than the benefit to society as measured by what people are willing to pay. For society as a whole—since the costs are outstripping the benefits—it would make sense to produce a lower quantity of such goods.

When perfectly competitive firms maximize their profits by producing the quantity where start text, P, end text, equals, start text, M, C, end text, they also ensure that the benefits to consumers of what they are buying—as measured by the price they are willing to pay—is equal to the costs to society of producing the marginal units—as measured by the marginal costs the firm must pay. Thus, allocative efficiency holds.

When we say that a perfectly competitive market in the long run will feature both productive and allocative efficiency, we need to remember that economists are using the concept of efficiency in a particular and specific sense, not as a synonym for “desirable in every way”. For one thing, consumers’ ability to pay reflects the income distribution in a particular society. Thus, a homeless person may have no ability to pay for housing because they have insufficient income.

Perfect competition, in the long run, is a hypothetical benchmark. For market structures such as monopoly, monopolistic competition, and oligopoly—which are more frequently observed in the real world than perfect competition—firms will not always produce at the minimum of average cost, nor will they always set price equal to marginal cost. Thus, these other competitive situations will not produce productive and allocative efficiency.

Moreover, real-world markets include many issues that are assumed away in the model of perfect competition, including pollution, inventions of new technology, poverty—which may make some people unable to pay for basic necessities of life—government programs like national defense or education, discrimination in labor markets, and buyers and sellers who must deal with imperfect and unclear information.

The theoretical efficiency of perfect competition does, however, provide a useful benchmark for comparing the issues that arise from these real-world problems.

Summary

Long-run equilibrium in perfectly competitive markets meets two important conditions: allocative efficiency and productive efficiency.
These two conditions have important implications. First, resources are allocated to their best alternative use. Second, they provide the maximum satisfaction attainable by society.

Self-check questions

Productive efficiency and allocative efficiency are two concepts achieved in the long run in a perfectly competitive market. In fact, these two types of efficiency are the reason we call it a perfectly competitive market. How would you use the concepts of productive efficiency and allocative efficiency to analyze other market structures and label them imperfect?

Explain how the profit-maximizing rule of setting start text, P, end text, equals, start text, M, C, end text leads a perfectly competitive market to be allocatively efficient.

Review questions

Will a perfectly competitive market display productive efficiency? Why or why not?
Will a perfectly competitive market display allocative efficiency? Why or why not?

Critical-thinking questions

Assuming that the market for cigarettes is in perfect competition, what do allocative and productive efficiency imply in this case? What do they not imply?
In the argument for why perfect competition is allocatively efficient, the price that people are willing to pay represents the gains to society and the marginal cost to the firm represents the costs to society. Can you think of some social costs or issues that are not included in the marginal cost to the firm? Or some social gains that are not included in what people pay for a good?