Question

Assume that economic actors are not profit maximizers. The reason might be a lack of insight, information, or the absence of the desire to maximize profits. Discuss the implications of discarding the profit maximization assumption for the effectiveness and efficiency of the market system.

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.

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.

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

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.

The theoretical efficiency of perfect competition does, however, provide a useful benchmark for comparing the issues that arise from these real-world problems.