The Perfect Competition Benchmark

Perfect competition achieves efficiency because it is a price taker. Each buyer in a factor market pays the going market price established by the overall market. Because this factor price is constant, it is equal to both average factor cost and marginal factor cost. As such, a profit-maximizing buyer in perfect competition not only equates marginal factor cost to marginal revenue product, it also equates factor price to marginal revenue product, which satisfies the efficiency criterion.

Taco Employment Efficiency

Because Waldo's Taco World is one of thousands of employers hiring the same basic type of worker and with each firm being a relatively small part of the overall market, it has no market control over the factor price. This makes Waldo's Taco World a price taker.

To maximize profit, Waldo's Taco World hires the number of workers that equates marginal revenue product and marginal factor cost, but being perfectly competitive, this is also equal to the going factor market price. If the going factor market price is $10, then Waldo's Taco World employs workers until marginal revenue product is also $10. Waldo's Taco World satisfies the equality between factor price and marginal revenue product and achieves efficiency.

To see why, a closer look at marginal revenue product and factor price seems in order.

• Marginal Revenue Product: Marginal revenue product consists of two parts, one is the marginal physical product--how much output a worker contributes to production, the other is the price of the product--the satisfaction consumers obtain from the output. When combined, marginal revenue product indicates the contribution a worker makes to consumer satisfaction.
  
  For example, if the marginal revenue product of a taco worker is $10, then the worker is producing tacos that generate $10 worth of satisfaction to the taco-buying public. In fact, to state this more precisely, the last worker employed by Waldo generates $10 worth of taco satisfaction.


• Factor Price: Factor price is the opportunity cost incurred by the factor of production when undertaking a given activity. As an opportunity cost, it is the highest valued production foregone. When workers are used to produce tacos, they are not being used to produce automobiles, sandwiches, soft drinks, or running shoes.The satisfaction that people DO NOT receive from the other goods NOT produced is the value of this foregone production.
  
  For example, if the factor price is $10, then the resources used to produce tacos could have produced other goods valued at $10. Again, being more precise, the value of the scarce resources used to produced the last taco could have produced another good valued at $10. A value of $10 means providing $10 worth of wants-and-needs satisfaction.

Inefficiency Alternatives

• Marginal Revenue Product is Greater than Factor Price: Suppose that the marginal revenue product of a worker ($11) is greater than the factor price ($10). In this case, the economy gives up less satisfaction from other goods not produced than it receives from the tacos that are produced. This is a great deal. It is a whole lot like society giving up $10 and receiving $11 in return. This is a trade few people would pass up.
  
  More to the point, this means that the economy is NOT employing enough taco workers. And if it decides to employ more workers, then satisfaction increases. By producing $11 worth of tacos with resources valued at $10, the economy obtains an extra $1 of satisfaction. But if it is possible to INCREASE satisfaction, then satisfaction must NOT be at its highest possible level.


• Marginal Revenue Product is Less than Factor Price: Now suppose that the marginal revenue product of a worker (say $9) is less than the $10 factor price. In this case, the economy is giving up more satisfaction from other goods not produced than it receives from the good that is produced. This is NOT a good deal. It is a whole lot like society giving up $10, but getting only $9 in return. This is a trade that few people would take.
  
  More to the point, this means is that the economy is using TOO MANY workers to produce tacos. If it decides to use fewer workers and produce fewer tacos, then satisfaction increases. By NOT producing $9 worth of tacos with resources valued at $10, the economy obtains an extra $1 of satisfaction. But once again, if it is possible to INCREASE satisfaction, then satisfaction must NOT be at its highest possible level.

The Other Market Structures

This market control means that firms face positively-sloped factor supply curves. Higher factor prices must be paid to buy larger factor quantities. But with higher prices come higher marginal factor cost, and marginal factor cost that exceeds factor price. At each factor quantity marginal factor cost is greater than factor price.

As such, when firms operating in monopsony, oligopsony, or monopsonistic competition hire the profit-maximizing factor quantity, they do so by equating marginal factor cost and marginal revenue product. But, because marginal factor cost exceeds factor price, marginal revenue product also exceeds factor price.