As you learned in your first course in economics, every society must decide how best to use its scarce labor, capital, natural and Environment Resources for production of goods and services. To get the most from society’s scarce resources, production and consumption must be organized in ways that avoid inefficient use of resources and inefficient consumption of goods and services. In this chapter, we examine efficiency from the larger perspective of society as a whole, rather than a single firm. Social economic efficiency exists when the goods and services that society desires are produced and consumed with no waste from inefficiency in either production or consumption. To reach this goal, two efficiency conditions must be fulfilled: productive efficiency and allocative efficiency. We will examine both of these conditions shortly.
Under ideal circumstances, a perfectly competitive market reaches an equilibrium that is both productively efficient and allocatively efficient. Unfortunately, market conditions are not always ideal (or even approximately so), and perfectly competitive markets then fail to bring about social economic efficiency. In this chapter, we will discuss and analyze the six reasons why competitive markets can fail to perform in a socially efficient fashion. You will see that imperfectly competitive market structures—monopoly, MONOPOLISTIC COMPETITION, and oligopoly—are never expected to achieve social economic efficiency because these market structures always lead to allocative inefficiency and, in some instances, may also fail to accomplish efficient production. The prospect that social economic efficiency can be reached through perfect competition is so compelling it serves as the foundation for antitrust policy in the United States, as well as competition policy in Canada, the European Union, and elsewhere around the world.
Efficiency Conditions for Society
As stated above, two efficiency conditions must be met to avoid waste and thus ensure that society enjoys the greatest gain possible from its limited resources. Markets must operate with productive efficiency so that society gets the most output from its resources. Productive efficiency exists when suppliers produce goods and services at the lowest possible total cost to society. Should markets fail to achieve productive efficiency for any reason, then resources will be wasted, diminishing the amounts of goods and services that can be produced in every industry. Managers produce at the lowest possible total cost by choosing the combination of inputs on the firm’s expansion path. Thus productive efficiency happens whenever managers operate along their firms’ expansion paths in both the short-run and long-run periods.
Allocative efficiency, the second condition needed for social economic efficiency, requires businesses to supply the optimal amounts of all goods and services demanded by society, and these units must be rationed to individuals who place the highest value on consuming them. Because productive resources are scarce, the resources must be allocated to various Industries in just the right amounts, otherwise too much or too little output gets produced. The optimal level of output is reached when the marginal benefit of another unit to consumers just equals the marginal cost to society of producing another unit. The price on the market demand gives the marginal benefit buyers place on consuming that extra unit of the good. Thus allocative efficiency requires production up to the point where the maximum price consumers are willing to pay for the last unit produced just equals its marginal cost of production. Since this is the point on demand where P = MC, economists frequently refer to this condition for efficiency as marginal-cost-pricing.
Let’s consider an example now. Suppose a market currently operates at the point on market demand where price is $100. At this output level, the value or marginal benefit of the last unit consumed is $100. At this output, suppose suppliers only need $60 worth of resources to make this last unit. Using the logic of marginal analysis, you can see that the current output level is too little, because an additional unit of output would add more total value (MB = $100) than it adds to total cost (MC = $60), thereby generating a net increase of $40 in social well-being. Now suppose that the market is operating at an output level for which consumers value the last unit at $35 and producers use $55 worth of scarce resources to make it. Now, too much output is produced, because it is inefficient to use $55 of resources to produce a good worth only $35 to consumers. Thus the optimal level of output is the unit for which demand price equals marginal cost.
Once society’s scarce productive resources are allocated efficiently among competing industries, the resulting output must then be rationed or distributed to the individuals in society who get the most value from consuming them. This is exactly what happens when buyers engage in voluntary market exchange. At the current market price, consumers whose demand prices (i.e., marginal valuations) equal or exceed market price will choose to buy the good. Consumers whose valuations are less than the current price will not buy any of the good, leaving more for those who value consumption of the good more highly. This process by which prices serve to ration goods to their highest-valued users through voluntary exchange is generally referred to as the rationing function of prices. We now summarize the conditions required for social economic efficiency in a principle.
Principle Social economic efficiency occurs when two efficiency conditions are met: (1) industry output is produced at the lowest possible total cost to society (productive efficiency), and (2) every industry produces the socially optimal amount of a good or service and these units are rationed or distributed to the individuals in society who value them most (allocative efficiency).
Social Economic Efficiency under Perfect Competition
Now we will show you that markets in perfectly competitive equilibrium achieve both productive and allocative efficiency.
Figure 16.1 shows demand and supply curves for a perfectly competitive industry. Supply curve S represents either short-run or long-run industry supply. In competitive equilibrium, 800 units are bought and sold at the market-clearing price of $60 per unit (point A). We will now explain why the competitive equilibrium at point A is both productively efficient and allocatively efficient.
Productive efficiency under perfect competition
As we explained, productive efficiency occurs when firms operate on their expansion paths, because input combinations on expansion paths—both short-run and long-run expansion paths—minimize the total cost of producing any particular level of output. Probably the most compelling reason to believe managers will actually operate on their expansion paths is rather simple, yet powerful: Economic profit cannot be maximized unless total cost is minimized for the profit-maximizing output level. Managers wishing to maximize profit and the value of their firms must operate on their expansion paths. This reasoning applies in both short- and long-run periods of production. In contrast to the short run, however, firms that fail to produce efficiently in the long run must exit the industry. These inefficient firms suffer losses at the long-run competitive equilibrium price—minimum longrun average cost—and will be forced either to produce efficiently or exit. As a further benefit of productive efficiency, consumers pay the lowest price possible for the good.
At point A in Figure 16.1, each firm in the industry produces its portion of total industry output by using the combination of inputs that minimizes its total cost of production. If S is a short-run industry supply curve, then the firms in the industry may earn positive, negative, or zero profit at the market price, $60. Alternatively, if S represents a long-run industry supply curve, then all firms earn zero economic profit and produce at their minimum average costs, $60. In either case, 800 units cannot be supplied at a lower total cost since all suppliers are producing on their expansion paths.
Allocative efficiency under perfect competition
Recall that demand prices along a market demand curve are exactly equal to the marginal benefits buyers receive by consuming another unit of a good. For this reason, market demand, D, in Figure 16.1 is also labeled “MB.” You learned that supply prices along both short-run and long-run industry supply curves equal the industry’s marginal cost of producing additional units of output. Thus industry supply S is also labeled “MC.”
Let’s suppose the industry produces 400 units of output. At this level of output, buyers place a value of $100 on getting an additional unit to consume, while sellers require $40 worth of extra variable inputs to produce an additional unit. Since MB (= $100) exceeds MC (= $40), the 400th unit should be produced since it adds $60 to net benefit. This reasoning applies to every unit up to 800 units. Any output beyond 800 units, however, is too much output since MC exceeds MB beyond 800 units. For example, at 1,000 units, variable inputs worth $70 are used to produce the 1,000th unit of output, but the extra good is only worth $40 to consumers. Clearly, production and consumption beyond 800 units is inefficient.
Allocative efficiency in a perfectly competitive industry must occur at the equilibrium output level determined by the intersection of demand and supply. At the point of competitive equilibrium, demand price (MB) equals supply price (MC). In Figure 16.1, you can verify that the marginal benefit of the 800th unit is $60, which equals the marginal cost of the 800th unit. Competitive equilibrium always establishes the optimal level of output for society, as long as the demand curve correctly and fully measures marginal benefits of consumption and the supply curve correctly and fully measures marginal costs of production. As we will show you in this chapter, demand and supply curves may not always correctly measure marginal benefits and costs. When this happens, competitive markets may produce either too much or too little output.
Finally, notice that the equilibrium price, $60, successfully rations 800 units of output to the consumers who value these goods most. Consumers with relatively low values, represented by the segment of demand below point A, do not voluntarily pay $60 to purchase output beyond the 800th unit because these units are worth less to them than the market price. These potential buyers voluntarily choose not to consume the good, leaving the 800 units for those buyers who place a value on the good of at least $60. Thus perfectly competitive markets achieve allocative efficiency because the optimal amount of the good is produced, and this amount is rationed or allocated to the highest-valued users.
Social economic efficiency and maximization of social surplus
We now wish to demonstrate that Social Surplus is maximized in competitive equilibrium. Consider again the 400th unit of output in Figure 16.1. The marginal value of this unit is $100. The buyer who purchases the 400th unit must pay the market price of $60 to get it, and so enjoys Consumer Surplus on this unit equal to $40 (= $100 - $60). The producer who supplies the 400th unit is willing to do so for a price as low as $40. The supplier of the 400th unit gains Producer Surplus equal to $20 (= $60 - $40). (Recall that the $20 producer surplus is economic rent if S in the figure represents long-run industry supply.) Thus, the consumption and production of the 400th unit generates $60 of net gain for society. By this reasoning, every unit for which demand price exceeds supply price contributes positively to society’s total surplus. As you can see from the figure, production and consumption of all units between 0 and 800 must be undertaken to maximize social surplus.
For consumption and production levels greater than competitive equilibrium— beyond point A in the figure—social surplus will be smaller than at point A. Consider the 1,000th unit, for which demand price, $40, is less than supply price, $70. Production and consumption of this unit are inefficient because $70 worth of scarce resources is transformed through production into a good worth only $40. Obviously, this would be wasteful for society. Fortunately, there is no price for this good that would stimulate buyers and sellers voluntarily to make such a wasteful transaction. Therefore, competitive market forces lead to the exact level of consumption and production that maximizes social surplus, and hence maximizes the value of this free market to society.
We must emphasize that, while competition maximizes social surplus, this does not imply that either consumer or producer surplus is maximized individually— it is the sum of the two that is maximized. Moving away from competitive equilibrium (point A) can result in one kind of surplus rising while the other surplus falls, but it must always reduce total social surplus. We can now summarize the Results of this section in a principle.
Principle Markets in perfectly competitive equilibrium achieve social economic efficiency because, at the intersection of demand and supply curves, conditions for both productive efficiency and allocative efficiency are met. At the competitive market-clearing price, buyers and sellers engage in voluntarily exchange that maximizes social surplus.