Question

Assuming that the market for cigarettes is in perfect competition, what does allocative and productive efficiency imply in this case? What does it not imply?

Short answer

In a perfectly competitive cigarette market, allocative efficiency is achieved when the price of cigarettes equals the marginal cost of production (P = MC), maximizing consumer and producer surplus. Productive efficiency is achieved when firms produce at the lowest possible average total cost (ATC). However, allocative and productive efficiency do not imply maximized societal welfare due to the negative externalities of cigarettes, such as health costs and environmental damage. Additionally, these efficiencies do not address income distribution or equity concerns.

Step-by-step solution

Define Allocative and Productive Efficiency

Allocative efficiency occurs when resources are allocated in such a way that consumer and producer surplus is maximized. In other words, allocative efficiency is achieved when the price of a good is equal to its marginal cost (P = MC). Productive efficiency is achieved when a firm produces at the lowest possible average total cost (ATC), meaning that the firm cannot produce the same output using fewer resources or at a lower cost.

Explain Perfect Competition

A perfectly competitive market has the following characteristics: 1. A large number of buyers and sellers 2. Homogeneous products, meaning that products are identical from different firms 3. Free entry and exit of firms in the market 4. Perfect information available to all market participants 5. Firms are price takers, meaning they have no control over the market price

Apply Allocative Efficiency to the Cigarette Market

In a perfectly competitive market for cigarettes, allocative efficiency is achieved when the price of cigarettes is equal to the marginal cost of producing them (P = MC). This means that the quantity of cigarettes produced and consumed in the market will be at the level where the benefits to consumers (as reflected by the price they are willing to pay) are equal to the costs borne by producers. Firms in such a market have an incentive to produce at the allocative efficient level because if they don't, other firms will enter the market and offer the good at a lower price, causing them to lose customers.

Apply Productive Efficiency to the Cigarette Market

In a perfectly competitive market for cigarettes, productive efficiency occurs when firms produce cigarettes at the lowest possible average total cost (ATC). Firms in perfect competition are price takers, meaning they have no control over the market price. Thus, to maximize profits, they need to minimize their costs. In the long run, firms that are not productively efficient will be forced to exit the market or improve their efficiency, due to the free entry and exit of firms under perfect competition.

Discuss what Allocative and Productive Efficiency Do Not Imply

It is important to note that allocative and productive efficiency in the cigarette market does not imply that the overall welfare of society is maximized. Cigarettes have negative externalities such as health costs and environmental damage, which are not considered when determining allocative efficiency in the market. Therefore, even if the market achieves allocative and productive efficiency, it may still lead to an overconsumption of cigarettes from a societal perspective. Moreover, allocative and productive efficiency do not imply income distribution or equity, as it does not take into account the distribution of resources among different groups of people. A perfectly competitive market may still result in unequal distribution of wealth or access to cigarettes, even if market efficiency is achieved.