Perfect Competition and Economic Efficiency

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Perfect Competition and Economic Efficiency
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Efficiency

• A state of the world is said to be efficient when
  all opportunities to make someone better off
  without making anyone worse off are exhausted
• most global conception, often called Pareto
  Efficiency
• Under ideal conditions, perfect competition is
  efficient

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Maximizing Net Social Benefit

• Under ideal conditions, including perfect
  competition and well-functioning markets, the
  market equilibrium maximizes the difference
  between the benefits society gets from goods and
  services and what it costs society to produce
  them
• required for Pareto efficiency

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• Market supply shows the marginal cost to society
  of producing the good or service
• Market demand is the marginal benefit to society
  from consuming the good or service
• Optimization (maximization of net social benefit)
  occurs where MSCMSB

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Supply and Marginal Social Cost

• We know from the theory of perfect competition
  that market supply is just the horizontal sum of
  each firms MC curve
• market supply shows what it costs to produce one
  additional unit of the good
• If ALL the costs are incurred by the firms, then
  supply equals Marginal Social Cost

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Demand and Marginal Social Benefit

• Economists measure benefits in terms of the
  willingness of consumers to pay
• Market demand shows the maximum willingness to
  pay for a unit of the good at each level of
  consumption

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Willingness to Pay

• Suppose that you have a collection of widgets
  that you want to sell
• Jane, Dick, Tom, and Harry are willing to pay the
  following maximum amounts for one widget

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• These individual willingnesses to pay trace out
  the demand for your widgets

If you set a price of 90, you will sell one
widget to Jane. At 50, you will sell three one
to Jane, one to Dick, and one to Tom.

Janes willingness to pay
100
Dicks willingness to pay
80
Toms willingness to pay
60
Harrys willingness to pay
40
Widgets
4
1
2
3
0
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• Now suppose that Jane would be willing to buy
  another if she could get it for no more than 50
• Suppose that Dick would also be willing to buy a
  second widget if he could get it for no more than
  20

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Janes willingness to pay for first widget
100
Dicks willingness to pay
80
Toms willingness to pay
60
Janes WTP for another
Harrys WTP
40
Dicks WTP for another
20
Widgets
1
2
3
4
5
6
0
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• Suppose there are hundreds of people who would be
  willing to buy one or more widgets
• The more buyers, the more steps on our graph
  until it looks like a smooth line

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All consumers whose WTP exceeds P1 will buy a
widget (or more if WTP at margin exceeds P1). The
Q1th unit is purchased by the consumer whose WTP
is just P1. Societys marginal benefit from
widgets is equal to the benefit (WTP) that the
consumer of the last unit enjoys.

P1
D
Q1
0
Widgets
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Putting MSC and MSB Together

• Where quantity supplied equals quantity demanded,
  MSC MSB
• If less is produced/consumed, then MSBgtMSC, which
  means that having more widgets adds to net social
  benefit
• If MSCgtMSB, then reducing the number of widgets
  saves more in cost than those widgets are worth

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S MSC
Net benefit of increasing production to Qe
Net benefit of reducing production to Qe
Net benefit of one more widget given Q1 is
being produced
Net benefit of one less widget given Q2 is
being produced
D MSB
Q
Qe
Q1
Q2
0
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Perfect Competition

• Remember the perfectly competitive equilibrium
• PMRMC
• each firm adjusts output to the point that price
  equals marginal cost
• the firm that produces the very last unit incurs
  a cost equal to the price of the good

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• Consumption is taken to the point at which the
  last unit consumed is just worth the price paid
  by the consumer
• In a perfectly competitive market, therefore, P
  MSC MSB
• perfect competition is efficient

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Perfect Competition and Efficiency
In equilibrium, P MSC MSB


S, MSC
MC
Pe
d, MR
D, MSB
qe
0
0
Qe
q
Q
Firm
Market