February, 2012 | The Economics Classroom

Allocative and Productive Efficiency in Perfectly Competitive Markets

Perfectly competitive markets, as rare as they are in reality, are useful to examine in theory, for they exhibit characteristics that no other market structure will exhibit. Specifically, perfectly competitive markets achieve a level of efficiency not likely to be seen in less competitive markets such as oligopoly, monopoly and monopolistic competition.

Efficiency in Economics is defined in two different ways: allocative efficiency, which deals with the quantity of output produced in a market, and productive efficiency, which requires that firms produce their products at the lowest average total cost possible. In perfect competition, both types of efficiency are achieved in the long-run.

This less will explain in detail what makes perfectly competitive markets economically efficient.

 

The relationship between the Current Account Balance and Exchange Rates

A nation’s balance of payments measures all economic transactions between that nation’s people and the people of all other nations. A country that spends more on imports than it earns from the sale of its exports is said to have a trade deficit. Such imbalances have become controversial topics of debate in political and economic circles, particularly over the last decade as the Chinese economy has emerged as the world’s largest exporter.

As goods and services flow from one country to another, the exchange rates of those countries’ currencies tend to fluctuate to promote balanced trade between the two nations. However, in some cases, most notably China, a country’s central bank will intervene in the market for its own currency to manage its exchange rate against that of a trading partner. When such interventions occur, the normal, moderating effect that rising and falling exchange rates has on trade flows is disrupted, and trade imbalances can become persistent.

This lesson will illustrate how trade flows should lead to appreciation and depreciation of currencies in a floating exchange rate system, and then explain how in the case of China, central bank policy aimed at buying large quantities of US government debt keeps the supply of Chinese currency high in the US and the demand for US dollars high in China. This means the dollar remains stronger than it otherwise might relative to the Chinese RMB, contributing to the persistent trade deficits the US exhibits in its trade with China.

 

The “Shut-down Rule” – When should a firm shut down to minimize its losses?

A firm in a competitive market may find itself experiencing economic losses if demand for its product falls or if the supply from other firms increases too rapidly. No one likes losing money, but should a firm get out of the market as soon as losses are experienced? Not necessarily.

If the losses a firm experiences are relatively small, it may be better off sticking things out and hoping price rises, returning the firm to a break-even level. However, if losses are greater than the firm’s fixed costs, the firm can actually minimize its losses by shutting down.

This lesson illustrates two situations in which a firm in a perfectly competitive market is earning economic losses. In one case, the losses are less than the firm’s total fixed costs. In another, the firm’s losses exceed its fixed costs, meaning the firm is better off shutting down.

 

From Short-run to Long-run in Perfectly Competitive Markets

Every firm would love to earn economic profits in the long-run. This is, after all the whole reason firms exist: to earn profits! But in perfectly competitive markets the likelihood of economic profits being earned in the long-run is very low, due to one key characteristic of such markets: the lack of entry barriers.

Likewise, if losses are being earned in the short-run, the ease with which firms can exit the market mean that, most likely, those losses will be eliminated in the long-run. This lesson will explain and illustrate the adjustments that perfectly competitive markets and firms undertake in the long-run in response to the existence of economic profits and losses. As we will see, perfectly competitive firms will, in all likelihood, break even in the long-run once firms have had the chance to adjust to the levels of profits or losses experienced.

 

Demand, Marginal Revenue and Profit Maximization for a Perfect Competitor

Perfect competition is a market structure in which thousands of identical firms compete to sell identical products, and in which no one firm has any control over the market price. Demand for and supply of the product in the market determines the price that each individual firm faces, and each firm can sell as much or as little output as it desires at the market price.

With these assumptions in mind, we will derive a demand curve for an individual perfect competitor’s output, which we will see is perfectly elastic. Facing the demand determined by the market, an individual firm must decide at what quantity its profits will be maximized. Using the profit maximization rule, any firm should be able to optimize its output to earn the highest per unit profit possible.

This video explains how an individual firm in a perfectly competitive market should decide the best quantity to produce to maximize profits.

 

Determining Comparative Advantage using PPCs – Worked solutions to AP Free Response Questions

Free trade based on the principle of comparative advantage promises to maximize the efficiency with which the world’s resources are allocated. But how do we know whether a country has a comparative advantage in the production of one good over another compared to its potential trading partners?

In this lesson we will work our way through several Advanced Placement Free Response Questions and show how, using production data from a PPC or a production possibilities table, we can calculate opportunity costs for particular goods in different countries, and then determine how countries stand to gain from trade based on comparative advantage.

 

Long-run Average Total Cost and Economies of Scale

When a firm has time to expand or reduce the amount of capital and land it employs in its production, it may find its average, per-unit production costs either rising or falling with the amount of capital it uses. This phenomenon is known as economies of scale (or size).

Sometimes, the larger a firm becomes, the more it produces, the lower its average costs of production. On the other hand, it is possible for a firm to become too big for its own good, and experience diseconomies of scale: when producing more output leads to rising average costs.

This lesson distinguishes between a firm’s short-run average total cost and its long-run average total cost, and explains how economies of scale may help a firm achieve lower average costs as it increases its output in the long-run.

 

The Relationships between Short-run Costs of Production

This lesson will examine the relationships between a firm’s short-run, per-unit costs of production: the marginal costs, average variable and average total costs of production (as well as, although not explicitly, the average fixed cost).

Previous lessons have explored the law of diminishing marginal returns, its effect on the productivity of a variable resource in the short-run (assumed to be labor) and how productivity and costs are related:

This lesson focuses on just the per-unit cost curves, their shapes, and the relationships between them. As you will see, the marginal cost curve, itself shaped by the law of diminishing returns, intersects the average cost curves at their lowest points, which as we will see in later lessons enables producers to choose a level of output at which their per unit production costs are minimized, enabling firms to make decisions that allow them to optimize their output for profit-maximization.

 

Short-run Productivity, Costs and the Law of Diminishing Marginal Returns

In the last lesson it was shown how the law of diminishing marginal returns affects the productivity of labor as a firm varies the number of workers employed towards the production of its output in the short-run. Due to the fact that capital and land are fixed in quantity, the addition of more workers to a factory will ultimately lead to the marginal product of labor declining, and even becoming negative if too many workers try to squeeze into a limited amount of space and work with a fixed number of tools.

The most significant implication of the law of diminishing marginal returns for a producer is the effect it has on a firm’s costs of production in the short-run. A firm’s variable costs are determined by the productivity of labor, since labor is the primary variable resource. When worker productivity is rising, a firm’s costs are falling; but when the firm begins experiencing diminishing marginal returns, productivity fall and the cost of additional units of output begins to rise.

This lesson illustrates using data and graphs the relationship between productivity and costs in the short-run, and how the law of diminishing marginal returns determines the shapes of the short-run cost curves: marginal cost and average variable cost.

 

Understanding the relationships between Total, Marginal and Average Product

This lesson is the second in the series on short-run costs of production and the law of diminishing returns. Before watching this video, make sure you’ve seen the last one in the series: THE LAW OF DIMINISHING RETURNS IN A TOY TRUCK FACTORY

In this lesson we will examine the changes in productivity experienced as more labor is added to a fixed amount of capital, measuring not only the total product, but also the marginal and average outputs of labor. Once we have output data in a table, we will graph the TP, MP and AP curve and examine the mathematical relationships between these curves.

Understanding the relationships between a firm’s short-run productivity curves will provide us with a basis for understanding how a firm’s costs of production change as the firm varies its level of output in the short-run.