Welfare effects of perfect

competition
17 October 2022
 Welfare effects of perfect competition
• It may be argued that an economy consisting entirely of perfectly competitive
markets leads to a maximisation of consumer satisfaction.

• This follows because, in long-run equilibrium, competition forces firms to

produce with the least- cost technology available, at the lowest possible average
per unit cost, and sell to consumers at a price that just covers this cost.

• In addition, P=MC balance implies that consumers pay a price that just covers
the cost of the last unit of each kind of good produced.

• Because of the ease of entry and exit of firms to and from industries, a perfectly
competitive economy will quickly re-allocated resources to meet changing
consumer preferences or reflect changing supply conditions.

• Hence, resources are always efficiently allocated in accordance with consumers’

tastes.
 Price Ceiling
• A price ceiling, also called price cap, is the maximum price that
a seller is allowed to charge for a particular good or service by
law.

• It is an instrument of market regulation that governments may

use to ensure that firms do not abuse their market power by
charging consumers excessively high prices.

• Particularly, for goods which are considered a necessity such as

water, electricity, or food, the government may establish price
ceilings to protect consumers.
 Price Ceiling
• In the case of a price ceiling,
producer surplus decreases.

• Consumer surplus may increase or

decrease depending on the demand
function and the height of the price
ceiling.

• Total welfare decreases, due to the

decrease in the quantity exchanged.

• The shaded orange area is the

efficiency loss that can be attributed
to the price ceiling.
 PC vs monopoly
• When compared to this market structure the market equilibrium is more
inefficient and results in lower welfare than compared to a perfectly
competitive market because of the fact that monopolists are price makers.
• The optimal output level for monopolists is below that of a perfectly
competitive market, as they set a higher price to maximise profits.
• As a result, this means that producer surplus increases because of the
higher price and consumer surplus decreases due to the higher price.
• However, as the loss of consumer surplus is larger than the gain in
producer surplus, there is an overall dead weight loss triangle created.
• Under a perfectly competitive market, social welfare is maximised as a
result of producing at the point of allocative efficiency.
• Therefore monopolists reduce the overall level of social welfare in the
economy, which is often why they are perceived as bad for an industry.
PC vs monopoly
 PC vs monopoly
• In terms of efficiency, monopolies are both allocatively and productively
inefficient.

• It is productively inefficient because the monopolist does not produce at

the minimum of the average cost curve.

• This is because the monopolist profit maximises and that production point
corresponds to an average cost that is above the minimum, resulting in
productive inefficiency.

• As for allocative efficiency, the monopolist has significant monopoly power,

so it sets a price above the marginal cost and the allocative efficiency
condition of P=MC is not met.