Question

In a perfectly competitive market, each firm maximizes its profit by choosing only the quantity to produce. Regardless of whether the firm makes an economic profit or incurs an economic loss, the short-run equilibrium is efficient. Is the statement true? Explain why or why not.

Short answer

The statement is true because, in short-run equilibrium, perfectly competitive markets achieve allocative efficiency (P = MC).

Step-by-step solution

- Understand the Market Structure

A perfectly competitive market is characterized by a large number of firms, identical products, and free entry and exit. Firms are price takers and cannot influence market price.

- Determine Profit Maximization

Each firm maximizes profit by producing a quantity where marginal cost (MC) equals marginal revenue (MR), which is also the price (P) in perfect competition. Hence, the condition for profit maximization is MC = P.

- Analyze Short-Run Equilibrium

In the short run, firms can be making an economic profit, breaking even, or incurring an economic loss. Regardless, each firm produces where MC = P.

- Assess Efficiency in Short-Run Equilibrium

Efficiency in economic terms means allocative efficiency, which occurs when the price of the good equals the marginal cost of production (P = MC). This condition is met in a perfectly competitive market, even in the short run.

- Conclude about the Statement

Given that the condition P = MC always holds in the short-run equilibrium of a perfectly competitive market, the production is allocatively efficient. Thus, the statement is true.

Key concepts

profit maximization

In a perfectly competitive market, firms aim to maximize their profits. Profit maximization occurs when a firm chooses the level of output where its marginal cost (MC) equals its marginal revenue (MR). In this perfect competition scenario, the market price (P) is also the marginal revenue because firms are price takers and cannot influence the price. Hence, the condition for profit maximization is given by MC = P. This ensures that each additional unit produced adds exactly the same amount to revenue and cost, helping the firm to maximize its overall profit or minimize losses.
This elegant condition encapsulates how firms make production decisions in a perfectly competitive market.

marginal cost

Marginal cost (MC) is a critical concept in understanding firm behavior in competitive markets. It represents the cost of producing one additional unit of output. For profit maximization, marginal cost must equal the market price (P).
If MC is less than the price, producing more units adds more to revenue than to cost, encouraging firms to increase production. Conversely, if MC exceeds price, producing more units adds more to cost than to revenue, prompting firms to decrease production.
Therefore, the point where MC = P is where firms will find their profit maximization point, balancing the cost of production and the revenue gained perfectly.

allocative efficiency

Allocative efficiency occurs when resources are distributed in a way that maximizes the net benefit received by society. In a perfectly competitive market, this is achieved when the price (P) of the good equals the marginal cost (MC) of production. This means that the value consumers place on a good (reflected in the price they are willing to pay) precisely matches the cost of producing it.
This alignment ensures that resources are used where they are most valued, neither overproducing nor underproducing relative to consumer demand. Consequently, even in the short run, a perfectly competitive market meets the criterion of allocative efficiency.

short-run equilibrium

In the short run, firms in a perfectly competitive market may experience different outcomes: economic profits, losses, or breaking even. Regardless of these varying financial outcomes, each firm produces where its marginal cost equals the market price (MC = P). This intersection ensures that the firm is making optimal production decisions given current market conditions.
Although firms might incur economic losses in the short run, they continue to operate as long as the revenue covers variable costs. Over time, these conditions guide firms either to adjust their output or to exit the market if losses are unsustainable. This constant adjustment leads to a dynamic equilibrium reflective of current market conditions.

economic profit

Economic profit takes into account both explicit costs (like wages and materials) and implicit costs (such as opportunity costs of capital). In a perfectly competitive market, economic profit can be positive, negative, or zero in the short run. A firm earns an economic profit when revenue exceeds total costs (including opportunity costs). This attracts new firms into the market, increasing supply and driving down prices until profits normalize to zero.
Conversely, if firms incur economic losses, they may exit the market, reducing supply and pushing prices up until the remaining firms break even. In the long run, firms in perfectly competitive markets typically earn zero economic profit, as market forces drive prices to a level where total costs, including opportunity costs, are covered.