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By the end of this section, you will be able to:
  • Apply concepts of productive efficiency and allocative efficiency to perfectly competitive markets
  • Compare the model of perfect competition to real-world 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 (terms that were first introduced in ( Choice in a World of Scarcity ) .

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 will be 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 thus ensuring that the social benefits received from producing a good are in line with the social costs of production.

To explore what is meant by allocative efficiency    , it is useful to walk through an example. Begin by assuming that the market for wholesale flowers is perfectly competitive, and so P = MC. Now, consider what it would mean if firms in that market produced a lesser quantity of flowers. At a lesser quantity, marginal costs will not yet have increased as much, so that price will exceed marginal cost; that is, P>MC. In that 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 will be greater than the costs.

Conversely, consider what it would mean if, compared to the level of output at the allocatively efficient choice when P = MC, firms produced a greater quantity of flowers. At a greater quantity, marginal costs of production will have increased so that P<MC. In that case, the marginal costs of producing additional flowers is 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 will make sense to produce a lower quantity of such goods.

Questions & Answers

what is the law of diminishing marginal utility
Samuel Reply
what is demand
Isatu Reply
other things can be equal an certain amount paid for the goods by consumer in the market called demand.
Dhanishhwar
demand is the amount of a commodity a consumer is willing and able buy at a given price at a particular point in time
Samuel
what is economics
Owusu Reply
meaning of economics
Agyei Reply
what is a columnist
Owusu
what are the four basic assumptions of perfect competition
Liyanda Reply
There is a well known maximum by economic that states that the birthd of money is the deaths of batter system discuss the statement
PHILIP Reply
how does price elasticity increase
Anuoluwapo Reply
What is real GDP
Klaudia Reply
Real GDP is a way of adjusting our output calculations for inflation so that we can see group interms of physical production quantity
Minalu
Real gross domestic product is a macroeconomic measure of the value of economic output adjusted for price changes. This adjustment transforms the money-value measure, nominal GDP, into an index for quantity of total output
amisha
what is economics
Preet Reply
Economics is the study of human behavior between scarcity and want.
Vincent
yesss thats it
Tendai
economics is the study of man and his behaviors
toheeb
yh all is correct
Paul
ECONOMICS IS THE STUDY OF,HOW HUMAN BEINGS MADE DECISIONS IN THE TIME OF SCARCITY.
Bakshi
According to Professor Lionel Robbins" Economics is a science which study human behaviour as a relationship between ends and scarce means which have alternative uses".
Paul
According to Adam Smith, "Economics is a science which inquired into the nature and cause of wealth of nations. "
Tannu
economics is a science that studies human behaviour as a relationship between ends and scarce means which have alternative uses
Efua
everyone is correct
Ruth
More questions
Paul
what is elasticity
RELEBOHILE Reply
a consumer has income of$3,000 wine is price at$3 a glass and cheese is price at$6 a kilo.draw the consumer's budget constraint . what is the slope of this budget constraint
Mohammed Reply
h
Thulani
by scientific method we mean
Lethu Reply
Inductive and deductive method
Bethuel
when  are producers willing to supply more goods and services in the market?
Ivan Reply
think about the essential goods that you need "on daily basis" .Are they really all essentials ..Could you live without some of them?
Ivan
what is scarcity
Azolingo Reply
Economics is a science which studies human behaviour as a relationship between ends and scarce which have alternative uses
Tannu
thanks
Rabiu
Whn demand of resources and more then it's availability or supply.
Abhishek
when there's less resources
Maybrien
scarcity is a situation where resources are not enough to satisfy all wants
Efua
types and characteristics of inflation in South Africa
Okuhle Reply

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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