Question

Explain why a perfectly competitive market maximizes social welfare.

Answer 1

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.

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

In this 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 would be greater than the costs.Hence Perfect competitive market maximizes the social welfare .