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Perfect Competition - Performance
Dr. Jennifer P. Wissink
©2011 John M. Abowd and Jennifer P. Wissink, all rights reserved.
Perfectly Competitive Market
Long Run Equilibrium
$
$
lratc
SRS w/N*
P*
A
P*
a
mr*=δ*
D
Q
Q*
MARKET
q
q*
typical firm
Long Run Performance Measures

What would Zeus want if he were an omnipotent
benevolent all knowing social planner?

Efficiency:
– Pareto/Allocative Efficiency
» An allocation, QPE is Pareto Efficient if no participant in the market can be
made better off (feasibly) without making at least one other participant
worse off.
» That is, at QPE net social surplus (NSS) in the market is maximized.
» NSS = $TBsociety - $TVCsociety
» When NSS is maximized, $MBsociety = $MCsociety
– Productive Efficiency
» Each firm operates at, at least, minimum efficient scale.
» Each firm operates at the minimum of its long run average total cost curve,
or qpe ≥ qmes.

Equity: Is the allocation fair? Equitable? Just?
– Good question that we do not answer here and now.
Will Long Run Market Equilibrium Under
Perfect Competition Be Efficient?
Is Q* Pareto Efficient? YES!
Is q* productively efficient?
$
YES!
$
lratc
SRS w/N*=MCsociety
P*
A
P*
a
mr*=δ*
D=MBsociety
Q
Q*
MARKET
q
q*
typical firm
The Invisible Hand



Adam Smith called the resource allocation efficiency
of competitive markets the “invisible hand.”
Even though all participants are only trying to
improve their own welfare, the result is that the
welfare of the entire market (economy) is maximized.
Competitive markets allocate
goods to the buyers and
sellers that have the highest
marginal benefits and lowest
marginal costs, respectively.
Competitive Markets are Pareto
Efficient Because:







Quantity demanded equals quantity supplied.
Demand represents marginal benefit. All those with
willingness to pay greater than or equal to the market
price buy. No one else buys.
Supply represents marginal cost. All those with seller’s
cost less than or equal to the market price sell. No one
else sells.
All transactions occur at the market price.
So, all consumers pay the same price (the market price).
And, all producers receive the same price (the market
price).
There is no transaction among the buyers and sellers that
improves the welfare of at least one person without
reducing the welfare of at least one other person.
Market Equilibrium

P
Short Run Supply=MC


P*
Demand=MB

Q*
Quantity
The long run
market equilibrium
occurs at P* & Q*.
Consumers’
surplus is the blue
shaded area
Producers’ surplus
is the red shaded
area
Net social surplus
is the blue and red
shaded area
First Fundamental Theorem of
Welfare Economics
 Modern
economists refer to the invisible
hand as the first fundamental theorem
of welfare economics.
 If there is a market for every good, and
if all markets are competitive (buyers
and sellers are price takers), then the
competitive equilibrium is Pareto
efficient (also called “Pareto optimal”).
Second Fundamental Theorem of
Welfare Economics
 Economists
have also established a second
property of competitive markets, called the
second fundamental theorem of welfare
economics.
 Any Pareto efficient outcome can be achieved
as a competitive equilibrium provided that all
redistributions are accomplished by lump-sum
transfers of wealth.
Why We Study Welfare
Economics



The invisible hand property of competitive markets
provides the justification for using economic competition
as the benchmark against which we measure the
efficiency and viability of other social institutions for
coordinating production and consumption.
The second fundamental theorem, although virtually
impossible to implement, shows that competitive markets
also provide the benchmark for measuring the efficiency
and viability of governmental programs designed to
redistribute wealth or income.
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