7.

3
Market Failure &
Socially Undesirable Outcomes
~PERFECT COMPETITION~
Allocative Efficiency
&
Evaluation

Source (unless otherwise noted): Tragakes, Ellie. Economics for the IB Diploma. Third ed., Cambridge University Press, 2020 (Chp. 7 (7.3))
Think about your earlier learning…

What are the conditions for achieving allocative efficiency in a

perfectly competitive market?
MB=MC

Now think about what you have learned about individual firms in a
perfectly competitive market…

What would be the condition of allocative efficiency

at the level of the individual firm?
 Allocative Efficiency
Allocative efficiency
● In the competitive market allocative and productive efficiency occurs when firms
is achieved when equilibrium is determined by MB=MC produce the particular
○ where consumer and producer surplus (sum=social combo of goods that
surplus) is at its maximum consumers mostly
○ this is focused on the efficiency of the market or prefer
industry

Now we look at how efficiency can be analysed at the level of the individual firm
● In this context, the condition for allocative efficiency is:
○ Allocative Efficiency is achieved when P = MC
Reason:
● Allocative efficiency is achieved when MB=MC
● Since MB=P it follows that there is allocative efficiency when P=MC

Note : this condition only happens when there are no externalities, in which case its also true that MSB=MSC (this was the condition for
getting allocative efficiency in chapter 5
Allocative Efficiency (Perfect Competition)
Price (P) → when paid by consumer reflects: When P = MC, there is equality
1. the marginal benefit they derive from consumption of between:
one more unit of the good; and 1. what consumers are
2. the amount they are willing to pay to buy one more prepared to pay, and
unit of good
2. what it costs to produce one
Marginal Cost (MC) → measures the value of the more unit
resources used to produce one extra unit of th good

Diagram B: The industry achieves allocative

efficiency at MB=MC, where social surplus is at
its maximum.

Diagram A: shows how efficiency at the level of

the individual firm corresponds to efficiency at
the level of the industry
★ In long run, allocative efficiency achieved:
Where firm earns normal profit at the maximum;
& level of output (Qe) and where P=MC
Allocative Efficiency (Perfect Competition)

Allocation of resources are allocated efficiently ONLY when P=MC

When does Allocative inefficiency result? If P > MC:

● An additional unit of the good is worth
more to consumers than the cost to
produce it
● In this situation, it means that:
○ there would be an
MB>MC
underallocation of resources to
its production; and
=MB
○ Consumers would be better off if
more if were produced.
P>MC ● Allocative Inefficiency Results
Q1
Q1
Allocative Efficiency (Perfect Competition)

Allocation of resources are allocated efficiently ONLY when P=MC

When does Allocative inefficiency result?

If P < MC:
● An additional unit of the good costs
more to produce than it is worth to
consumers
● In this situation, it means that:
○ There is an overallocation of
P<MC resources to production of the
MC>MB good; and
=MB ○ Consumers would be better off if
output were reduced
● Allocative Inefficiency Results
Q2 Q2
 Efficiency and Perfect Competition in LR
In long run equilibrium under perfect competition:
● the firm achieves both:
○ allocative efficiency (where P=MC); and
○ productive efficiency (where production is at
minimum of ATC)

At the industry level social surplus (consumer + producer

surplus) is maximum and MB=MC

The achievement of allocative and productive efficiency

in the LR equilibrium is important, because perfect
competition is the only market structure in where this
happens
Productively efficient means the
firms are using resources efficiently
and are producing output in the
least-cost manner and with no
waste (P=min. ATC)
Efficiency in Perfectly Competitive Markets:
 Evaluating Perfect Competition
We know that in the real world, perfect competition is not very realistic as a
market structure

However, it is the only market structure where allocative efficiency is achieved

→ the only market structure that does not fail

It provides insights on the competitive market and allows us to see its limitations
as well.
 Evaluating Perfect Competition ~ Insights
Allocative Efficiency
● Perfect competition leads to the “optimal” allocation of resources
● Achieved through P=MC (or MB=MC) in the long run

Low prices for Consumers

● Consumer benefit from low prices due to:
○ production at the lowest possible cost; and
○ the absence of economic profits (which would lead to a higher price)

the price when economic profit

(abnormal profit) is higher than
the price in the Long run
equilibrium where the firm earns
only normal profit
 Evaluating Perfect Competition ~ Insights
Competition leads to closing down of inefficient producers
● Inefficient firms are those who produce at higher than necessary costs
● Inefficiency could be due to factors like less productive labour, outdated
technology or poor entrepreneurship
● The revenues of inefficient firms are insufficient to cover all costs, leading to
losses that force these firms to exit the industry in the LR

The market responds to consumer tastes

● Changes in tastes are reflected in changes in market demand and therefore
market price
● By creating SR abnormal profit (or economic profit) or losses, price changes
result in LR adjustments that make the quantity of output produced respond
to the changes in taste
Evaluating Perfect Competition ~ Limitations
Unrealistic Assumptions
● Assumptions of perfect competition are rarely met in
the real world

Cannot take advantage of economies of scale

● Economies of scale lead to lower average costs as a
firm grows larger
● In perfect competition the requirement that firms are
many and small prevents them from growing to a size
large enough to take advantage of economies of
scale

Image Source: marketbusinessnews.com

Evaluating Perfect Competition ~ Limitations
Lack of product variety
● All firms within an industry produce identical and or undifferentiated products
– a disadvantage to consumers who prefer product variety

Limited ability to engage in new product development

● The lack of economic profits in the LR does not give firms the necessary $ to
engage in R&D

Waste of resources in the process of long run adjustment

● The continuous opening and closing of firms as the industry responds to
changes in demand, resource prices and technology in the LR may lead to a
waste of resources (the model unrealistically assumes there are no costs of
adjustment)
Evaluating Perfect Competition ~ Limitations
Market failure
● Even if it were possible to meet all of the assumptions of the perfectly
competitive market model, there are numerous real world situations where
resources are allocated inefficiently due to market failures