A purely competitive industry whether decreasing cost, increasing cost or a constant cost one should have some basic characteristics so that in long-run we may be able to talk about its economic efficiency. In a long Run a triple equation exists: P (Marginal Revenue) =MC =minimum ATC, which besides giving us information about economic profit or loss that our firm gains in short-run, tells us that in long-run a firm may get only a normal profit. This equation also suggests certain conclusions about Allocative and Productive efficiency of our economic unit in long-run.
Productive efficiency requires goods to be produced at least costly way, but allocative efficiency requires goods to be divided among industries that yield most needed combination of products by society. Let’s see how productive and allocatice efficiency is realized in purely competitive market.
Productive efficiency: P= Minimum ATC
In long run, pure competition forces firms to produce their goods at minimum average total costs and to charge price relative to cost of production, which is a situation that benefits consumers. If firms don’t use these least-cost production methods they may get high losses and at a point in time leave the market. In this case minimum quantity of resources is used to produce these goods.
Let’s take for example a firm that produces 1000 kg of tomatoes. To cover all its cost of production it should sell all this quantity at price of 5$ per kg ( 5000$ totally). If another firm produces the same quantity for 9000$ then society will face a loss of 4000$ of alternative products. However, this loss can’t happen in pure competition, because this big loss may require our firm to leave the market.
Consumer benefits this kind of efficiency by paying lowest possible cost.
Allocative Efficiency: P=MC
Productive efficiency alone doesn’t ensure to get the efficient mix of good, also least cost production must be used to provide society the most needed mix of products. But what does the products’ price means?
- Price of any product is the society’s measure of marginal unit of a good. Price of a tomato is the marginal benefit society gets from using it.
- Price of one more unit of any good is the opportunity cost society sacrifice to get it. If we produce any additional tomatoes we sacrifice growing more units of corn.
Let’s see the cases when this equation doesn’t take place.
Underallocation P>MC
In pure competition a firm realizes the maximum profit when price of a good equals to its marginal cost. Producing tomatoes at points where MR (Price) is greater than MC (P>MC) yields less than maximum profit. This means that society is underallocating resources for producing this good, so that one more unit of tomato is valued by society higher than other products that our resources can produce.
Overallocation P<MC
Production of tomatoes shouldn’t go beyond the price where marginal cost exceeds marginal revenue (Price). If we produce at a point where MC (marginal cost) is higher than marginal revenue, than the producers won’t obtain maximum profit. So it is an overallocation of resources to this produce. In our case by producing tomatoes at the point where (P<MC) means that we sacrifice goods used at production of tomatoes, which society values higher than tomatoes.
Efficient Allocation
So conclusion is that in a pure competition, firms should produce at a point where MR(Price)=MC, so that each item will be allocated efficiently in our society. To produce cucumber at a point where P>MC, means that we sacrifice production of goods, which society values very high, but at the point where P<MC it’s overallocation of resources, at production of which are used resources that may produce goods valued higher.
Fast Adjustments
Another important characteristic of purely competitive market is ability to change quantity output when there are some changes in consumer’s taste. So if cucumbers now become more popular initially their price will increase, so that P>MC, this fact will permit cucumber industry to take away resources from less profitable uses, let’s say potato. So cucumber industry will expand.
Similarly a change in supply of a particular resource will create a change in labor force, production technique or capital (machines). Thus managers have to reallocate all resources very fast until P=MC.
Invisible Hand
Highly efficiency of allocating resources in a purely competitive market makes resource suppliers to seek to further their self-interests. This is the invisible hand which operates in our competitive market system. This kind of market system not only makes a patter to maximize profits but also maximized consumers’ satisfaction. Invisible hand operates good suppliers in such a way that society’s interests are maximized by using scarce resources.
Finance & Economics!!! 