Explain how perfect competition should lead to outcomes which are both productively and allocatively efficient

AQA A-Level Economics Paper 1 November 2021

Explain how perfect competition should lead to outcomes which are both productively and allocatively efficient.

Perfect competition is a market structure that is characterised by many buyers and sellers, identical products, perfect information, and no barriers to entry or exit.

In the short run, the outcomes of perfect competition can be seen by this diagram.

The diagram on the left shows that the market price is determined by market supply and market demand. All firms (right) are price takers so the firm's AR curve follows this price. Firms are profit maximisers so they can achieve maximum profit by choosing to sell the quantity where MC = MR. In the short run, the firm is demonstrating allocative efficiency because, at q1, AR = MC. This means that consumer and producer surplus (total welfare in society) is being maximised.

The firm becomes both allocatively and productively efficient in the long run. Because there are supernormal profits and no barriers to entry, new firms will enter the market. This means that market supply will shift to the right. As a result, each firm gets less demand because there are more perfect substitutes available. The diagram below shows the new price which is lower and quantity which is higher. Also, there is no supernormal profit for firms in the market.

The long-run outcome is allocatively efficient as AR = MC and productive efficiency as firms operate at the lowest point of the AC curve (AR = MC). In context, this means that firms are minimising costs and fully exploiting their economies of scale.