Efficiency and Markets

Efficiency and Markets

Efficiency occurs when the use of scarce resources leads to socially desirable outcomes. An efficient firm uses resources in such a way that there is a welfare gain for the society. A firm is productively efficient if it produces at the lowest point on the average cost curve; allocative efficiency occurs when the price paid by consumers is equal to the marginal cost of making the product while dynamic efficiency involves improving the product and processes to meet the changing wants of the consumers over time.

Efficiency of firms in a perfectly competitive market
There are two types of efficiency possible in this type of market structure, namely productive and allocative efficiency. In the short run, the business is going to achieve allocative efficiency because the price and marginal cost are equal (P=MC) at the profit maximising output level. The profit maximising output or equilibrium occurs where marginal revenue and marginal cost are equal.  However, it is impossible to be allocatively efficient because the firm is not producing at the lowest cost possible, i.e. lowest point on the average cost curve.

Figure 1: Efficiency in perfectly competitive market in the short run
 Efficiency in perfectly competitive market in the short run

The firm will be both productively and allocatively efficient in the long run. The firm will be productively efficient since it is producing at the lowest point on the average cost curve. Also, it achieves equilibrium where the price is equal to marginal cost.

Figure 2: Efficiency in perfectly competitive market in the long run

Efficiency in perfectly competitive market in the long run
The firms cannot attain dynamic efficiency in this type of market because it is made up of many small firms that cannot afford to invest in the required technology and research and development that assures innovation.  There is a need for a lot of abnormal profit which is short-lived in this market since it occurs only in the short run. The absence of barriers means there will be more entrants into the market in the long run and abnormal profit will fizzle out.

Efficiency of firms in an imperfectly competitive market
There is hardly any type of efficiency in an imperfect market structure. Both productive and allocative efficiency are lacking in all types of imperfect market structures. But monopolists can attain dynamic efficiency owing to the fact that their abnormal profits cannot be competed away; the substantial barriers in a monopoly mean that the dominant firm can generate abnormal profit all the time and have enough to embark on innovation, research and development which are the hallmarks of a firm that can achieve dynamic efficiency.

Efficiency in monopolistic competition
The firm does not attain productive and allocative efficiency in both the short run and long run. Price and marginal cost curve do not intersect or meet at the profit maximising output Q in the short-run (Figure 3 below) and long-run (Figure 4). So there is no allocative efficiency since price and marginal cost are not equal. Also, the firm does not produce at the output level where the average cost is at the lowest in both the short run and long run,i.e. there is no productive efficiency.

Figure 3: Efficiency in monopolistic competition in the short run

Efficiency in monopolistic competition in the short run

Figure 4: Efficiency in monopolistic competition in the long run

Efficiency in monopolistic competition in the long run

Efficiency in monopoly
Monopoly can only achieve dynamic efficiency out of the three types of efficiency being considered. The monopolist is the only firm in the industry in the short and long run. It does not produce at the lowest point on the average cost curve (corresponding to point N in Figure 5 below) or where the price is equal to marginal cost. In order words, it can neither be productively efficient nor allocatively efficient in the short and long run. But the existence of abnormal profit all the time assures that the firm has ample funds to invest in technology and research and development; it, therefore, can attain dynamic efficiency. This will lead to a fall in the firm’s long-run average cost. This is beneficial to the consumers as they have access to innovative products and can enjoy lower prices if the monopolist decides to pass the gains of lower long-run average cost to them.

Figure 5: Efficiency in monopolistic competition in the long run

Efficiency in a monopoly