Question

In a perfectly competitive industry, at long term equilibrium, a firm discovers a better process, which increases his marginal productivity. Graph and explain the effect on his company and upon the industry as the information spreads. Short run and long run.

Answer 1

Efficiency in perfectly competitive markets

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.

Productive efficiency means producing without waste so that the choice is on the production possibility frontier. In the long run, in a perfectly competitive market—because of the entry and exit process—the price in the market is equal to the minimum of the long-run average cost curve. In other words, goods are being produced and sold at the lowest possible average cost.

Allocative efficiency means that among the points on the production possibility frontier, the chosen point is socially preferred—at least in a particular and specific sense. In a perfectly competitive market, price is equal to the marginal cost of production. Think about the price paid for a good as a measure of the social benefit received for that good; after all, willingness to pay conveys what the good is worth to a buyer. Then think about the marginal cost of producing the good as representing not just the firm's cost but, more broadly, as the social cost of producing that good.

When perfectly competitive firms follow the rule that profits are maximized by producing at the quantity where the price is equal to marginal cost, they ensure that the social benefits received from producing a good are in line with the social costs of production.

Let's walk through an example to more thoroughly explore what is meant by allocative efficiency. Let's begin by assuming that the market for wholesale flowers is perfectly competitive, so \text{P} = \text{MC}P=MCstart text, P, end text, equal, start an M, C, end text. Now, consider what it would mean if firms in that market produced a lesser quantity of flowers. At a lesser quantity, marginal costs would not yet have increased as much, so the price would exceed marginal cost: \text{P} > \text{MC}P>MCstart text, P, end text, is greater than, start a text, M, C, end text.

In this situation, the benefit to society as a whole of producing additional goods—as measured by consumers' willingness 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 well. In other words, the gains to society from producing additional marginal units would be greater than the costs.

On the other hand, consider what it would mean if—compared to the output level at the allocatively efficient choice where \text{P} = \text{MC}P=MCstart text, P, end text, equals, start a text, M, C, end text—firms produced a greater quantity of flowers. At a greater quantity, marginal costs of production would increase so that \text{P} < \text{MC}P

When perfectly competitive firms maximize their profits by producing the quantity where \text{P} = \text{MC}P=MCstart text, P, end text, equals, start a text, M, C, end text, they also ensure that the benefits to consumers of what they are buying—as measured by the price they are willing to pay—is equal to the costs to society of producing the marginal units—as measured by the marginal costs the firm must pay. Thus, allocative efficiency holds.

When we say that a perfectly competitive market, in the long run, will feature both productive and allocative efficiency, we need to remember that economists are using the concept of efficiency in a particular and specific sense, not as a synonym for “desirable in every way.” For one thing, consumers’ ability to pay reflects the income distribution in a particular society. Thus, a homeless person may have no ability to pay for housing because they have insufficient income.

Perfect competition, in the long run, is a hypothetical benchmark. For market structures such as monopoly, monopolistic competition, and oligopoly—which are more frequently observed in the real world than perfect competition—firms will not always produce at the minimum of average cost, nor will they always set price equal to marginal cost. Thus, these other competitive situations will not produce productive and allocative efficiency.

Moreover, real-world markets include many issues that are assumed away in the model of perfect competition, including pollution, inventions of new technology, poverty—which may make some people unable to pay for basic necessities of life—government programs like national defense or education, discrimination in labor markets, and buyers and sellers who must deal with imperfect and unclear information.