Question

What is economic efficiency? Why are purely competitive industries economically efficient and monopoly industries are not efficient?

Answer 1

What is Economic Efficiency?

Economic efficiency is when all goods and factors of production in an economy are distributed or allocated to their most valuable uses and waste is eliminated or minimized.

Economic efficiency implies an economic state in which every resource is optimally allocated to serve each individual or entity in the best way while minimizing waste and inefficiency. When an economy is economically efficient, any changes made to assist one entity would harm another. In terms of production, goods are produced at their lowest possible cost, as are the variable inputs of production.

In perfect competition, market prices reflect complete mobility of resources and freedom of entry and exit, full access to information by all participants, homogeneous products, and the fact that no one buyer or seller, or group of buyers or sellers, has any advantage over another.

Perfect competition can be used as a yardstick to compare with other market structures because it displays high levels of economic efficiency.

Perfect competition and economic efficiency

Economic efficiency with perfect competition

Allocative efficiency:

• In both the short and long run we find that price is equal to marginal cost (P=MC) and thus allocative efficiency is achieved.
• At the ruling price, consumer and producer surplus are maximised.
• No one can be made better off without making some other agent at least as worse off – i.e. we achieve a Pareto optimum allocation of resources.

Productive efficiency:

• Productive efficiency occurs when the equilibrium output is supplied at minimum average cost.
• This is attained in the long run for a competitive market.
• Firms with high unit costs may not be able to justify remaining in the industry as the market price is driven down by the forces of competition.

Dynamic efficiency:

We assume that a perfectly competitive market produces homogeneous products – in other words, there is little scope for innovation designed purely to make products differentiated from each other and allow a supplier to develop and then exploit a competitive advantage in the market to establish some monopoly power.

Monopoly

A monopoly exists when a specific enterprise is the only supplier of a particular commodity. Monopolies have little to no competition when producing a good or service. A monopoly is a business entity that has significant market power (the power to charge high prices).

Inefficiency in a Monopoly

In a monopoly, the firm will set a specific price for a good that is available to all consumers. The quantity of the good will be less and the price will be higher (this is what makes the good a commodity). The monopoly pricing creates a deadweight loss because the firm forgoes transactions with the consumers. The deadweight loss is the potential gains that did not go to the producer or the consumer. As a result of the deadweight loss, the combined surplus (wealth) of the monopoly and the consumers is less than that obtained by consumers in a competitive market. A monopoly is less efficient in total gains from trade than a competitive market.

Monopolies can become inefficient and less innovative over time because they do not have to compete with other producers in a marketplace. For private monopolies, complacency can create room for potential competitors to overcome entry barriers and enter the market. Also, long term substitutes in other markets can take control when a monopoly becomes inefficient.