CH11 MARKET POWER: PERFECT COMPETITION AND MONOPOLISTIC

COMPETITION
Pages: 182-185

Outline 11.3
I. How efficient are firms in perfect competition?
A. When considering efficiency, we need to look at two different ways
of measuring it.

1. Productive efficiency
a) One of the efficiency measures used by economists is
that of productive efficiency. A firm is said to be
productivity efficient if it produces its product at the
lowest possible unit cost (average cost).
(1) This is shown in Figure 11.8
b) At the output q, the firm in Figure 11.8 is able to
produce at the most efficient level of output, ie the
lowest average cost of production.
(1) This is the cost c. So q is known as the
productivity efficient level is where: MC=AC
c) Productive efficiency is important in economics
because if a firm is producing at the productively
efficient level of output then they are combining their
resources as efficiently as possible and resources are
not being wasted by inefficient use.

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2. Allocative efficiency
a) We have already come across allocative efficiency in
chapter7.
b) This is the measure of efficiency is sometimes also
called the socially optimum level of output.
c) Allocative efficiency occurs where suppliers are
producing the optimal mix of goods and services
required by consumers.
d) Price reflects the value that consumers place on a
good and is shown on the demand curve (average
revenue).
(1) The marginal cost reflects the cost to society of
all the resources used in producing an extra
unit of a good, including the normal profit
required for the firm to stay in business.
(2) If price were to be greater than marginal cost,
then the consumers would value the good
more than the cost it was to make.
(3) If both sets of stakeholders are to meet at the
optimal mix, then the output would expand to

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 the point where the price equals marginal cost.
Similarly, if the marginal were to be greater
than the price, then society would be using
more resources to produce the good than the
value it gives to consumers and output would
fall.
(4) Allocative efficiency occurs where marginal
cost (the cost of producing one more unit) is
equal to average revenue (the price received
for a unit).
(5) In Figure 11.9, we can see the allocatively
efficient level of output for a firm with a normal
demand curve and for a firm with a perfectly
elastic demand curve.
(a) In both cases, we are looking for the
output where MC=AR, which is q1 for
the firm with a normal demand curve,
and q2 when the demand is perfectly
elastic.
(6) Allocative efficiency is important in economics
because if a firm is producing at the allocatively
efficient level of output there is a situation of
“Pareto optimality” where it is impossible to
make one person better off without making
someone else worse off.
(a) If a firm is making abnormal profits in
the short run in perfect competition, we
can see from Figure 11.10 that although
they are producing at the
profit-maximizing level of output,q
(where MC=MR), and the allocatively
efficient level of output, q2 (where
MC=AR), the firm is not producing at the
most efficient level of output, q1 (where
MC=AC).

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 (7) In the same way, if a firm is making losses in
the short run in perfect competition, we can
see from Figure 11.11 that although they are
producing at the profit-maximizing level of
output, q (where MC=MR), and the allocatively
efficient level of output, q2 (where MC=AR),
once again the firm is not producing at the
most efficient level of output, q1 (where
MC=AC).

II. Is there a market failure that needs to be rectified in perfect competition?

A. As we can see in Figure 11.12, profit-maximizing firms in the long
run in perfect competition all produce at the lowest point of their
long-run average cost curves.
1. Because we assume that there is perfect knowledge in the
industry, all the firms will face the same cost curves, and so
they are all selling at the same price and minimizing their
average costs by producing where MC=AC.
B. Also shown in Figure 11.12 is the fact that all of the
profit-maximizing firms in the long run in perfect competition are

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also producing at the allocative efficient level of output because
they produce where MC=AR.
1. This means that there is no market failure involved in perfect
competition since we know that market failure exists when a
firm fails to produce at the allocatively efficient level of
output. This in turn means that there is no need for
government intervention in perfectly competitive markets to
rectify any market failure.
a) The market power of perfectly competitive firms is
non-existent since they are price-takers.

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