Fall, 2000 Mark Healy
Economic Efficiency
In a purely competitive market, firms employ resources until the marginal cost of the last unit of a good equals its price. In the absence of external costs (e.g., pollution) or external benefits (e.g., education, inoculations), the opportunity cost to society of these resources equals the marginal cost of the resources to producers. If there are no externalities (discussed in depth in a later chapter), these resource costs equal their marginal social costs (MSC) – the value to society of the resources used to produce one more unit of a good. Competition through freedom of entry and exit ensures that this is at the lowest possible average cost and that there is no waste in production. A purely competitive economy is an efficient economy, both allocatively and technically. One aspect of economic efficiency is that all goods must be produced at their lowest possible opportunity cost (technical efficiency). Competition meets this requirement by ensuring production at minimal LRATC. Allocative efficiency requires the mix of goods produced to match consumer preferences. Here again, competition meets the criterion because consumers get the products they want at the least opportunity cost.
Social Welfare
Positive economic analysis cannot directly address the fairest way to divide the pie. If we assume, however, that the proper distribution of income is a normative problem at best settled in the political arena and that the resulting political outcome is viewed as acceptable, then the competitive market system is not only efficient; it also maximized social welfare. Here is why.
Your demand curve for any good is based on the marginal benefits (utility) that you would receive from consuming various possible amounts of the good, as we discussed in our "Consumer Choice" chapter. Our assumptions imply that the marginal utility you receive from consuming is also the marginal benefit society receives. That is, your gain is also society’s gain because you are a member of society. When we sum all consumer demands, we derive the market demand curve for an industry’s product, which is also the marginal social benefit (MSB) to all of society from having a bit more of the good.
With consumer benefits and producer costs in mind, we can refer to the industry supply and demand curves, respectively, as the marginal social cost (MSC) and marginal social benefit (MSB) curves. When a purely competitive industry is in a long-run equilibrium, marginal social cost equals marginal social benefit (MSC = MSB): The industry is producing where the marginal social benefit from the last unit produced is just equal to the marginal social cost of the resources needed to produce that unit of product. This concept is illustrated in Figure 15.
The MSB = MSC conditions is optimal from society’s point of view. Since the opportunity costs of resources represent alternatives for all of society, we want our resources to be used as efficiently as possible. If production were inefficient, then it would be possible for some people to gain without imposing losses on others.
Consider output level Qo in Figure 15. The social benefit from a bit more output than Qo is Po which greatly exceeds the cost (P1) of the resources required to produce a little more of the good, so society as a whole could gain if more resources were used to produce more of this good. And in a competitive industry, they will be. If Qo were initially produced and sold at price Po existing firms in a competitive industry would enjoy economic profit. This would cause the industry to grow until equilibrium output Qo is reached at a price and (average and marginal) production cost of P1. The adjustment process is just reversed if industry output exceeds Qo. Competitive markets tend to squeeze the last bit of gain possible from the resources available.
Microeconomics by Ralph T. Burns and Gerald M. Story
Harper Collins, New York 1993, pp. 210-212