Question

Summarize how market equilibrium in perfect competition results in productive efficiency and allocative efficiency.

Answer 1

Market equilibrium in perfect competition is when Price (P) = Marginal Cost (MC).

Productive efficiency means when an economy has to sacrifice the production of another good to produce another good. All points on the Production Possibility Curve (PPC) are said to be productive efficient, whereas points inside the PPC are productive inefficient.

In the long run, perfect competitive firms produce where the price is equal to the minimum of the long run average cost curve and there is free entry and exit until and unless all the firms are making normal profits. Hence, perfect competitive firms are said to be productive efficient.

Allocative efficiency occurs when the distribution of any goods or services is optimal according to consumer's preferences. Allocative efficiency occurs when the Price is equal to the Marginal Cost.

In perfect competition, the equilibrium is at the point where Price (P) = Marginal Cost (MC). Lets consider an example. If at a quantity of 10 units, the marginal cost of producing the good for each unit is $6 but the market equilibrium price is $12 for each unit, then the the market equilibrium price is greater than the marginal cost. This shows there is under consumption in the society. In this case, if the firm increased production, the benefit the society would get would be higher than the cost of producing that good or service. Hence, if the quantity produced increased and price decreased until the Marginal Cost is equal to the Price, the society would be get benefit.

Similarly, lets consider the case where at a quantity of 30 units, the marginal cost of producing the good for each unit is $12 but the market equilibrium price is $6 for each unit, then the marginal cost is greater than the market equilibrium price. This shows there is over consumption in the society. In this case, if the firm continued to increase production, the cost of producing that good or the service would be higher than the benefit to the society. Hence, if the quantity produced decreased and the price increased until the Marginal Cost is equal to the Price, the firm would get benefit.