Question

Productive efficiency and allocative efficiency are two concepts achieved in the long run in a perfectly competitive market. These are the two reasons why we call them "perfect." How would you use these two concepts to analyze other market structures and label them "imperfect?"

Short answer

In summary, other market structures, such as monopoly, oligopoly, and monopolistic competition, are considered "imperfect" because they do not achieve both productive and allocative efficiency like perfectly competitive markets do. Productive efficiency is not achieved because firms do not necessarily operate at the lowest point on their average cost curve, and allocative efficiency is compromised due to price-setting practices, market power, and product differentiation, resulting in under- or over-production of goods and services.

Step-by-step solution

Understand Productive and Allocative Efficiency

Productive efficiency refers to producing goods and services at the lowest possible cost. It occurs when a firm is operating at its lowest point on the average cost curve, which means it is producing the maximum output with a given amount of input. Allocative efficiency occurs when resources are allocated in such a way that consumer preferences are satisfied. In other words, goods and services are produced and distributed according to consumer demand, and there is no under- or over-production of any item. Perfectly competitive markets are considered "perfect" because they achieve both productive and allocative efficiency in the long run.

Analyzing Market Structures

Let's analyze three main market structures other than perfectly competitive markets: monopoly, oligopoly, and monopolistic competition. We will assess their productive and allocative efficiency to understand why they are considered "imperfect."

Monopoly

A monopoly is a market structure where there is only one seller that controls the entire supply of a product or service. Monopolies often involve significant barriers to entry for competitors, which allows the sole firm to maintain control over the market. Productive Efficiency: Monopolies do not necessarily operate at the lowest point on their average cost curve, as they have no incentive to minimize costs due to lack of competition. Thus, monopolies are not productively efficient. Allocative Efficiency: Monopolies typically set prices higher than marginal cost, as they have the market power to set prices and maximize profits. This results in a deadweight loss to society, as some consumers are priced out of the market. Thus, monopolies are not allocatively efficient.

Oligopoly

An oligopoly is a market structure where a small number of firms dominate the market. These firms often compete on factors other than price, such as branding and product differentiation. Productive Efficiency: Oligopolies may not be productively efficient, as firms do not always produce at the lowest point on their average cost curve. They may continue operating even with excess capacity, which contradicts productive efficiency. Allocative Efficiency: In an oligopoly, firms set prices higher than marginal costs and engage in price competition or collusion. This can lead to under-production or over-production of goods, which results in allocative inefficiency.

Monopolistic Competition

Monopolistic competition is a market structure where many firms sell differentiated products with some substitution possibilities but which are not perfect substitutes. Each firm has some control over market prices but faces downward-sloping demand curves due to competition from other firms. Productive Efficiency: Firms in monopolistic competition do not necessarily produce at the lowest point on their average cost curve, as they face downward-sloping demand curves. Thus, monopolistic competition may not be productively efficient. Allocative Efficiency: In a monopolistically competitive market, firms set prices above marginal cost, which can result in allocative inefficiency. However, given the product differentiation and variety, consumer preferences may be better satisfied in comparison to other imperfect market structures. In conclusion, monopoly, oligopoly, and monopolistic competition markets are considered "imperfect" because they deviate from achieving both productive and allocative efficiency. These deviations arise due to market power, price-setting practices, entry barriers, and product differentiation.