Question

Will a perfectly competitive market display allocative efficiency? Why or why not?

Short answer

A perfectly competitive market will display allocative efficiency as the market price equals the marginal cost of production and the marginal benefit consumers derive from consuming the good. This ensures optimal allocation of resources and a supply of goods and services that match consumers' preferences without waste.

Step-by-step solution

Understand Allocative Efficiency

Allocative efficiency occurs in a market when the distribution and allocation of resources are optimized, meaning that the goods and services produced match the consumers' desires and preferences. It is achieved when the production of goods and services in an economy is accomplished at the lowest possible cost and meets the needs and wants of consumers without any waste. In other words, allocative efficiency happens when the marginal cost (MC) of producing one more unit of a good is equal to the marginal benefit (MB) consumers get from consuming it. Mathematically, it can be represented as: \( MC = MB \)

Understand Perfect Competition

A perfectly competitive market is characterized by the following features: 1. There are a large number of buyers and sellers. 2. The products sold by the various sellers are homogeneous, meaning they are identical in quality and features. 3. There is perfect knowledge among the buyers and sellers about the market. 4. There is free entry and exit of firms in the market. 5. Sellers are price-takers and have no market power to influence the price of their product. In a perfectly competitive market, the price is determined by the interaction of supply and demand. The market price equals the marginal cost of production, which implies that firms produce at their lowest possible cost.

Link Allocative Efficiency and Perfect Competition

In a perfectly competitive market, firms are profit maximizers. They will produce and sell goods until their marginal revenue (MR) equals their marginal cost (MC). Since firms in perfect competition are price-takers, the price remains constant and is equal to the marginal revenue: \( P = MR \) As the firms produce goods by equating MR and MC, we have: \( P = MR = MC \) Now, recall that in our previous step, allocative efficiency occurs when marginal cost equals marginal benefit: \( MC = MB \) Comparing the two conditions, we can see that in a perfectly competitive market: \( P = MR = MC = MB \)

Conclusion

A perfectly competitive market will display allocative efficiency. This is because, in such a market, the price is equal to the marginal cost of production, as well as to the marginal benefit that consumers derive from consuming the good. Thus, resources are allocated optimally, and the supply of goods and services matches consumers' preferences without any waste, achieving allocative efficiency.