Chapter 8: Problem 29

Will a perfectly competitive market display allocative efficiency? Why or why not?

Short Answer

Expert verified

A perfectly competitive market will display allocative efficiency because, under such market conditions, resources are allocated based on supply and demand, which results in market price being equal to the marginal cost of production. This maximizes social welfare by ensuring that marginal cost equals marginal benefit to consumers.

Step by step solution

Define allocative efficiency

Allocative efficiency occurs when resources are distributed in such a way that it is not possible to reallocate them to make any one individual or group better off without making at least one other individual or group worse off. In other words, a market achieves allocative efficiency when it satisfies customer demands at the lowest possible cost.

Understand perfectly competitive market

A perfectly competitive market is a theoretical market structure that has the following characteristics: a large number of buyers and sellers, identical (homogeneous) products, perfect information available to all market participants, no entry or exit barriers, and no single participant has control over the market price.

Analyze the price mechanism in a perfectly competitive market

In a perfectly competitive market, supply and demand determine the market price. When supply and demand are in equilibrium, the market price is equal to the marginal cost of production. This means that firms will produce goods until their marginal cost equals the market price – no more, no less.

Determine allocative efficiency in a perfectly competitive market

In a perfectly competitive market, firms will produce goods until their marginal cost (MC) equals the market price (P). Since the market price represents the marginal benefit (MB) to consumers, we can say in a perfectly competitive market marginal cost (MC) equals marginal benefit (MB). This situation represents allocative efficiency because resources are being allocated in a way that maximizes the total surplus in the market. As a result, we can conclude that:

Conclusion

A perfectly competitive market will display allocative efficiency because allocation of resources is based on supply and demand that ensures the market price is equal to the marginal cost of production, which maximizes social welfare.