Question

Explain why a perfectly competitive agricultural firm (a farm) is perfectly efficient in the long run having achieved allocative efficiency,productive efficiency, and zero economic profit.

Answer 1

It is the type of market where price is determined by forces of demand and supply. Here, a firm is not a price maker but a price taker. In the sense any firm which tries to increase it's price from market determined price will lose it's buyers.In the long run, perfectly competitive firms will react to profits by increasing production. They will respond to losses by reducing production or exiting the market. Ultimately, a long-run equilibrium will be attained when no new firms want to enter the market and existing firms do not want to leave the market, as economic profits have been driven down to zero.

Zero Profits in the Long Run

The market is in long-run equilibrium, where all firms earn zero economic profits producing the output level where P = MR = MC and P = AC. No firm has the incentive to enter or leave the market. Let’s say that the product’s demand increases, and with that, the market price goes up. The existing firms in the industry are now facing a higher price than before, so they will increase production to the new output level where P = MR = MC.This will temporarily make the market price rise above the average cost curve, and therefore, the existing firms in the market will now be earning economic profits. However, these economic profits attract other firms to enter the market. Entry of many new firms causes the market supply curve to shift to the right. As the supply curve shifts to the right, the market price starts decreasing, and with that, economic profits fall for new and existing firms. As long as there are still profits in the market, entry will continue to shift supply to the right. This will stop whenever the market price is driven down to the zero-profit level, where no firm is earning economic profits.. In the long run, firms making losses are able to escape from their fixed costs, and their exit from the market will push the price back up to the zero-profit level. In the long run, this process of entry and exit will drive the price in perfectly competitive markets to the zero-profit point at the bottom of the AC curve, where marginal cost crosses average cost.

Productive 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 process of entry and exit, 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.Productive efficiency occurs when the equilibrium output is supplied at minimum average cost. By improving these processes, an economy or business can extend its production possibility frontier outward, so that efficient production yields more output.

Here we see MC=AC that's the point where firm is productive efficient and also MC cuts AC at it's lowest point. In the case of Perfect Competition, a firm produces at productive efficient level of output q₁ as shown in the diagram. A perfectly competitive market will have both productive efficiency and allocative efficiency in the long run.

Allocative efficiency

A state of the economy in which production represents consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing. Allocative efficiency means that among the points on the production possibility frontier, the point that is chosen is socially preferred—at least in a particular and specific sense. In a perfectly competitive market, price will be equal to the marginal cost of production. Think about the price that is 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 cost for the firm, 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 price is equal to marginal cost, they are thus ensuring that the social benefits received from producing a good are in line with the social costs of production. if, compared to the level of output at the allocatively efficient choice when P = MC, firms produced a greater quantity of flowers. At a greater quantity, marginal costs of production will have increased so that P < MC. In that case, the marginal costs of producing additional flowers is greater than the benefit to society as measured by what people are willing to pay. For society as a whole, since the costs are outstripping the benefits, it will make sense to produce a lower quantity of such goods.

Referring the above diagram this is the socially optimal level of output. At this point it is impossible to make one person better off without making someone else worse. There is pareto optimality.It occurs where MC = AR, In other words, a firm in a perfectly competitive market produces at the profit maximising level which is MR=AR. This is also the point where MC=AR. Thus we conclude that in perfect competition there is allocative efficiency in the long run.

Hence by studying all the effects of  allocative efficiency,productive efficiency, and zero economic profit in the long run we can say they do not provide any losses to a farm in perfectly competitive market.  Allocative efficiency and Productive efficiency,these two conditions have important implications. First, resources are allocated to their best alternative use. Second, they provide the maximum satisfaction attainable by society hence a farm will be perfectly efficient in long run.