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Perfect competition is an idealised form of the market – the set of conditions under which a perfectly competitive market could exist are rarely found in reality. Why do we then study perfect competition? The main attraction of perfect competition is that pricing mechanism implied by it leads the market to function in such a way that it cannot be further improved.
In reality, markets are less than perfect and so the outcome is less than desirable. Perfect competition is an yardstick for the evaluation of other market forms. In particular, efficiency of all market forms is to be judged in the light of efficiency of perfect competition.
In this article we will show how a competitive market structure satisfies the requirements of economic efficiency. The concept of economic efficiency has two components productive efficiency and allocative efficiency.
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1. Productive Efficiency:
Productive efficiency requires that the production of a good should be organised in such a way that per units cost is minimised and the price charged is equal to per unit cost. That is output of an activity should be carried up to that point at which price equals the minimum average cost.
This is a situation which is most desirable from the point of view of the consumers the price that they pay is the least cost price. The competitive pricing rule P = min. LAC satisfies the requirement of productive efficiency.
2. Allocative Efficiency:
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Allocative efficiency requires that the allocation of resources to an activity should be determined on the basis of maximum aggregate benefit enjoyed by the buyers and the sellers. In other words, the resource allocation to a productive activity is said to be efficient if neither the buyers nor the sellers can be made better-off by reorganizing production and consumption.
In a competitive market, the amount of a product that is bought and sold is determined by the equality of demand price and supply price. For any given quantity of output the demand curve shows the demand price, i.e., the maximum amount that the buyers are willing to pay for one extra unit of output.
The demand price is often interpreted as the marginal utility (MU) or marginal benefit of consumption. So, we can take demand curve as the MU curve of the buyers. For any given quantity of output, the supply curve shows the supply (cost) price of one extra unit of output, i.e., the MC of production (remember that under perfect competition, supply price is determined by MC).
So, we can interpret the supply curve as the MC curve of the industry.
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If Fig. 21.27 the demand curve (D) is also the MU curve and the supply curve (S) is the MC curve. The demand-supply intersection at E implies P (MU) = MC. The market clears at a price of P0 and quantity of Q0 units. Because P0 is the price paid by buyers for each extra unit of output, we can take P0 as the MC of purchase to the buyers.
The price P0 is the amount received by the sellers for each extra unit of output. So P0 can be interpreted as the marginal benefit or marginal revenue (MR) to the sellers. Then the equilibrium at E means the equality of MU of purchase and the MC of purchase on the one hand and the equality of MC of production and the MR from production on the other hand.
To understand the implication of the market equilibrium at E, we start with a position of the equilibrium. Suppose the quantity of output is Q1 units. At this output level MU of purchase is higher than its marginal cost to the buyers. So, the consumption of one extra unit of the good will add more to utility than to cost.
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This means that the consumer derives a net additional benefit from one extra unit of purchase. The consumer can profitably (in the sense of increasing total net benefit) increase consumption up to Q0 units. If consumption rises above Q0 units, MU < P0, i.e., additional utility from one extra unit of purchase is less than the additional cost of purchasing that extra unit.
Then the consumption above Q0 units is not profitable. The consumers, therefore, derive maximum net utility by purchasing Q0 units at the given price P0. Hence MU = P0 is the rule for maximising the satisfaction of the buyers in a competitive market.
We, now, turn to the behaviour of the sellers. If output is produced, P0 (= MR) > MC. Then, the production of one extra unit adds more to revenue than to cost so that profit rises And profit can be increased until MR = MC at Q0 units. The production should not rise above Q0 units, otherwise MR (P0) will fall below MC.
Hence, P0 = MC is the rule for maximising the profits of the sellers in a competitive market. The competitive pricing rule P0(MR) = MC ensures that both the buyers and the sellers independently maximise their self-interest (net utility for the buyers and profit for the sellers).
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The resource allocation to support the production of Q0 units is efficient because neither the buyers nor the sellers can be made better-off by choosing any other output level.
Optimal Resource Allocation:
In perfect competition the free market mechanism leads to an optimal allocation of resources.
The optimality is ensured by the following conditions which prevail in the long- run equilibrium of the competitive industry:
1. Output is produced at the minimum feasible cost.
2. Consumers pay the lowest possible price which is just sufficient to cover the marginal cost of producing the commodity, that is, P = opportunity cost.
3. Plants are used at full capacity in the long run, so that no resources are wasted and there is no scope for deriving economies of scale and reducing costs further.
4. Firms earn only normal profits.
These conditions prevail in all markets which are in long-run equilibrium. If we assume for simplicity that only two commodities (X and Y) are produced in the economy we can use the production possibilities curve (frontier) to show the allocation of resources. Consumers’ preferences are shown by the community (social) indifference curves.
Given the PPC and consumers’ preferences, perfect competition will ensure an optimal allocation of resources under the following conditions:
1. Consumers’ sovereignty:
Consumers’ sovereignty, expressed by the free play of the market forces (in the absence of government intervention) reflects the correct ranking of preferences of the community.
2. Exhaustion of economies of scale:
In both the industries (X and Y) economies of scale must be fully exhausted.
3. Unchanged stock of resources and technology, static economy:
Resources and technology are given. There is no growth in the economy and no technical progress, i.e., the economy is static. If the above three conditions are fulfilled, perfect competition leads to an optimal allocation of resources as shown by the point of tangency between the given PPC and the highest attainable community indifference curve (CIC2). In Fig. 21.28 optimal allocation of resources is reached at point E.
The economy ends up using all the available resources (point E lies on the PPC) and consumers attain the maximum possible welfare, given the fixed endowment of resources or factor inputs. The optimal allocation is attained at the prices PX and PY at which the levels the output of the two commodities are OX0 and 0Y0.
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