Efficiency Condition

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.

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

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

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

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

P = SRMC = LRMC = SRAC = LRAC