Question

Describe two reasons why perfectly competitive markets maximize economic efficiency.

Answer 1

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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.

Think of the market price as representing the gain to society from a purchase, since it represents what someone is willing to pay. Think of the marginal cost as representing the cost to society from making the last unit of a good. If P > MC, then the benefits from producing more of a good exceed the costs, and society would gain from producing more of the good. If P < MC, then the social costs of producing the marginal good exceed the social benefits, and society should produce less of the good. Only if P = MC, the rule applied by a profit-maximizing perfectly competitive firm, will society’s costs and benefits be in balance. This choice will be the option that brings the greatest overall benefit to society.

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