Perfect Competition - Economic Efficiency | tutor2u Economics
Study notes

Perfect Competition - Economic Efficiency

  • Levels: A Level
  • Exam boards: AQA, Edexcel, OCR, IB

In perfect competition, market prices reflect complete mobility of resources and freedom of entry and exit, full access to information by all participants, homogeneous products, and the fact that no one buyer or seller, or group of buyers or sellers, has any advantage over another.

Perfect competition can be used as a yardstick to compare with other market structures because it displays high levels of economic efficiency.

Perfect competition and economic efficiency
Economic efficiency with perfect competition

Allocative efficiency:

  • In both the short and long run we find that price is equal to marginal cost (P=MC) and thus allocative efficiency is achieved.
  • At the ruling price, consumer and producer surplus are maximised.
  • No one can be made better off without making some other agent at least as worse off – i.e. we achieve a Pareto optimum allocation of resources.

Productive efficiency:

  • Productive efficiency occurs when the equilibrium output is supplied at minimum average cost.
  • This is attained in the long run for a competitive market.
  • Firms with high unit costs may not be able to justify remaining in the industry as the market price is driven down by the forces of competition.

Dynamic efficiency:

We assume that a perfectly competitive market produces homogeneous products – in other words, there is little scope for innovation designed purely to make products differentiated from each other and allow a supplier to develop and then exploit a competitive advantage in the market to establish some monopoly power.

Perfect Competition - Chain of Reasoning

Is perfect competition good for economic efficiency?

Some economists claim that perfect competition is not a good market structure for high levels of research and development spending and the resulting product and process innovations.

Indeed it may be the case that monopolistic or oligopolistic markets are more effective long term in creating the environment for research and innovation to flourish. A cost-reducing innovation from one producer will, under the assumption of perfect information, be immediately and without cost transferred to all of the other suppliers.

That said a contestable market provides the discipline on firms to keep their costs under control, to seek to minimise wastage of scarce resources and to refrain from exploiting the consumer by setting high prices and enjoying high profit margins. In this sense, competition can stimulate improvements in both static and dynamic efficiency over time.

The long run of perfect competition, therefore, exhibits optimal levels of economic efficiency. But for this to be achieved all of the conditions of perfect competition must hold – including in related markets.

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