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 “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.