Allocative Efficiency of Perfectly Competitive Markets

Allocative Efficiency of Perfectly Competitive Markets and Applications

Definition

Perfectly competitive market model is characterized by the following major characteristics[1]:

• Market participants act as price takers as their number is virtually infinite or at least highly fragmented market not one of the participants is big enough to influence the price

• The law of one price is in effect due to the homogeneity of products and the assumption that all the participants are equally informed

• Entrance and exit to and from the market are virtually free due to equal access to required resources for existing and potentially new players

Other characteristics, such as zero transaction costs, non-increasing returns of scale or perfect factor mobility are either included into the abovementioned factors or can be considered the direct outcomes.

Assuming profit-maximizing attitude accepted by all the market participants, producer in a perfectly competitive market will choose his short-term production quantities based on the condition when the given price P equals the firm’s marginal costs MC.

After P=MC equilibrium is reached, marginal costs of production of every other unit will be higher than the price, effectively decreasing the firm’s profits. In the long run the firms will try to optimize their production facilities to reach the point where P=MC=AC or average total costs as Figure 1 shows.

Figure 1. Source: http://en.wikipedia.org/

Pareto Efficiency

Allocation of limited resources is considered efficient if there are no further Pareto improvements possible. Pareto efficiency is achieved when no single individual can be made better off without any other individual made as least as much worse off[2]. Figure 2 shows potential Pareto improvements for point A, lying within the limits of EF curve.

Normally, the economic system is Pareto efficient, when 3 kinds of efficiency are reached[3]:

• Exchange efficiency

• Input...