Competitive markets and efficiency

We begin our analysis with the concept of a perfectly competitive market for a good, which is defined as a market in which (in addition to assumptions about property rights and contract law which we examine throughout the book) it is also the case that:

  • • The costs of transacting are low;
  • • All firms and consumers are price takers;
  • • Firms can freely enter and exit the industry; and
  • • Firms sell identical goods, and both firms and consumers have enough information to accurately estimate the quality of the product and the prices that are charged by other firms.

The forces of competition create powerful individual incentives which lead to an allocation of resources which maximises net benefits.

To illustrate the link between competition and efficiency, consider a market in which all consumers are identical, and that consumers have identical quasi-linear utility functions, with the benefits of consumption of Q units of the good denoted by u(Q). Suppose that there are n identical firms (where n is determined endogenously in the long run), each with a cost function of C(q). Thus, total welfare in this economy is

Under these conditions, maximising total benefits minus total costs is equivalent to maximising the sum of consumer surplus (that is, willingness to pay) and producer surplus. We will refer to an allocation which maximises the sum of consumer surplus and the producer surplus as an efficient allocation. This is the efficiency concept we will use throughout the book.

In this setting, efficiency requires two conditions. First, for a given number of (identical) firms, it must not be possible to increase welfare by having each firm produce more. This means that:


That is, marginal consumption benefits must equal marginal costs.

Second, for a given quantity, it must not be possible to increase welfare by changing the number of firms. This means that:


This states that marginal consumption benefits must also equal average costs. Since the consumer equates marginal benefits with price P, welfare maximisation requires price = marginal cost = average cost.

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