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INCREASING MARGINAL RETURNS: In the short-run production of a firm, an increase in the variable input results in an increase in the marginal product of the variable input. Increasing marginal returns typically surface when the first few quantities of a variable input are added to a fixed input. Compare this with decreasing marginal returns. You should also compare this with economies of scale associated with long-run production.

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PERFECT COMPETITION, EFFICIENCY:

Perfect competition is an idealized market structure that achieves an efficient allocation of resources. This efficiency is achieved because the profit-maximizing quantity of output produced by a perfectly competitive firm results in the equality between price and marginal cost. In the short run, this involves the equality between price and short-run marginal cost. In the long run, this is seen with the equality between price and long-run marginal cost at the minimum efficient scale of production.
The conditions of perfect competition, including: (1) large number of small firms, (2) identical products sold by all firms, (3) freedom of entry into and exit out of the industry, and (4) perfect knowledge of prices and technology, ensure that perfect competition efficiently allocates resources. In fact, this is a primary role of perfect competition: a market structure that illustrates perfection, the best of all possible resource allocation worlds.

Efficiency Condition

An efficient allocation of resources is achieved if it is not possible to increase society's overall level of satisfaction by producing more of one good and less of another good. Such efficiency is achieved by a firm if the price of a good is equal to the marginal cost of production.

Consider how the equality between price and marginal cost results in efficiency.

  • Price: The price that buyers are willing to pay for a good indicates the satisfaction generated from producing and consuming the good. If a good generates more satisfaction, then society is willing to pay a higher price.

  • Marginal Cost: The marginal cost of production indicates the satisfaction foregone from the production of other goods. If foregone production generates more satisfaction, then the marginal cost of production is higher.
If price is equal to the marginal cost, then the value of the good produced is equal to the value of goods not produced. The satisfaction obtained from production is just matched by the satisfaction foregone for other production.

In this way, society cannot squeeze any additional satisfaction out of resources by producing more of one good and less of another.

If, however, price and marginal cost are not equal, then satisfaction can be increased.

  • Price > Marginal Cost: If price exceeds marginal cost, then the satisfaction obtained from the good produced is greater than the satisfaction foregone from other production. As such, society can increase overall satisfaction by producing more of the good.

  • Price < Marginal Cost: If price falls short of marginal cost, then the satisfaction obtained from the good produced is less than the satisfaction foregone from other production. As such, society can increase overall satisfaction by producing less of the good.

Zucchini Production

The Efficiency of
Profit Maximization
Profit Maximization
Consider how this efficiency is achieve for a hypothetical, representative perfectly competitive firm, such as Phil the zucchini growing gardener. Because Phil is one of gadzillions of zucchini producers, each producing identical products and each being a relatively small part of the overall market, he has no market control.

As such, Phil is a price taker and a hypothetical representation of a perfectly competitive firm. He produces the profit maximizing quantity of zucchinis that equates price and marginal cost. If the going market price is $4, then Phil produces zucchinis until his marginal cost is also $4. This equality between price and marginal cost (P = MC) is the key to efficiency.

The exhibit to the right displays the profit-maximizing production decision for Phil the zucchini grower. He faces typical U-shaped cost curves, especially a U-shaped marginal cost curve labeled MC. He also faces a horizontal, perfectly elastic, demand curve, which is also marginal revenue, and is labeled MR. Profit maximization results when Phil produces 7 pounds of zucchinis given by the intersection of the $4 marginal revenue curve and the marginal cost curve.

Short-Run Efficiency

Phil's zucchini production is efficient because price is equal to marginal cost. The value of the zucchini production ($4 per pound) is equal to the marginal cost of foregone satisfaction (also $4 per pound).

Or to state this more precisely, the last pound of zucchinis produced with the economy's scarce resources generates $4 worth of satisfaction. And the value of the scarce resources used to produce the last pound of zucchinis could have been used to produce some other good (carrots? cucumbers? kumquats?) valued at $4.

This means that society is allocating scarce resources in the production of zucchinis such that it is not possible to increase total satisfaction by producing more zucchinis or fewer zucchinis. This is it, this is as good as it gets.

Short-Run Inefficiency

Suppose that price and marginal cost are not equal. Suppose that the marginal cost of zucchini production ($3) is less than the zucchini price ($4). In this case, the economy gives up less satisfaction from other goods not produced than it receives from the zucchinis that are produced. This is a great deal, a whole lot like trading $3 for $4. Who would not take a trade like that?

What this means, however, is that the economy is NOT producing enough zucchinis. And when it produces more zucchinis it increases satisfaction. For each $4 worth of zucchinis produced with resources valued at $3, the economy obtains an extra $1 of satisfaction. But if it can take steps to INCREASE satisfaction, then it must not be getting the highest possible satisfaction with the current production.

A similar story can be told if the marginal cost of zucchini production (say $5) is greater than the $4 zucchini price. In this case, the economy is giving up more satisfaction from other goods not produced than it receives from the zucchinis that are produced. This is NOT a good deal, a whole lot like trading $5 for $4. Who would what a trade like that?

What this means is that the economy is producing TOO MANY zucchinis. If it reduced the production of zucchinis, then it would increase satisfaction. For each $4 worth of zucchinis produced with resources valued at $5, the economy loses $1 of satisfaction. As such, by NOT producing these zucchinis, satisfaction increases by $1. Of course, if the economy can take steps to INCREASE satisfaction, then it must not be getting the highest possible satisfaction with the current production.

Long-Run Efficiency

Not only does perfect competition generate efficiency in the short run, it also efficiently allocates resources in the long run. The long-run adjustment of firms entering and exiting the industry as each firm in the industry maximizes profits generates the following long-run equilibrium condition:
P = SRMC = LRMC = SRAC = LRAC
This condition means that the market price is equal to marginal cost (both short run and long run) and average cost (both short run and long run). With price equal to marginal cost, each firm maximizes profit and has no reason to adjust its quantity of output or factory size. Moreover, with price equal to average cost, each firm in the industry earns only a normal profit. Economic profit is zero and there are no economic losses.

This long-run equilibrium condition is ONLY satisfied at the minimum of the long-run average cost curve, also termed the minimum efficient scale. The economy cannot utilize scarce resources for production more efficiently that at the minimum efficient scale.

<= PERFECT COMPETITION, DEMANDPERFECT COMPETITION, FACTOR MARKET ANALYSIS =>


Recommended Citation:

PERFECT COMPETITION, EFFICIENCY, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2014. [Accessed: August 1, 2014].


Check Out These Related Terms...

     | perfect competition, profit maximization | perfect competition, loss minimization | perfect competition, shut down | perfect competition, short-run supply curve | short-run production alternatives | breakeven output | perfect competition, revenue division |


Or For A Little Background...

     | perfect competition | perfect competition, characteristics | efficiency | scarcity | minimum efficient scale | U-shaped cost curves | profit maximization | marginal cost | price | profit | economic profit | marginal cost | marginal revenue | production |


And For Further Study...

     | perfect competition, demand | long run industry supply curve | perfect competition, short-run production analysis | perfect competition, long-run production analysis | perfect competition, total analysis | perfect competition, marginal analysis | perfect competition, profit analysis |


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