― Murray N. Rothbard
General Equilibrium and the Efficiency of Perfect Competition
(Part B)
by
Charles Lamson
Allocative Efficiency and Competitive Equilibrium
Thus far in this analysis we have built a complete model of a simple, perfectly competitive economic system; however, recall that we made a number of important assumptions. We assumed that both output markets and input markets are perfectly competitive---that is, that no individual household or firm is large enough relative to the market to have any control over price. In other words, we assumed that firms and households are price-takers.
We also assumed that households have perfect information on product quality and on all prices available, and that firms have perfect knowledge of technologies and input prices. Finally, we said that decision-makers in a competitive system always consider all the costs and benefits of their decisions, that there are no "external" costs.
If all these assumptions hold, the economy will produce an efficient allocation of resources. As we relax those assumptions one by one, however, you will discover that the allocation of resources is no longer efficient and that a number of sources of inefficiency occur naturally.
Pareto Efficiency
There are several specific criteria used by economists to judge the performance of economic systems and to evaluate alternative economic policies. These criteria are (1) efficiency, (2) equity, (3) growth, and (4) stability. An efficient economy is one that produces the things that people want at least cost. The idea behind the efficiency criterion is that the economic system exists to serve the wants and needs of the people. If resources can be somehow reallocated to make the people "better off," then they should be. We want to use the resources at our disposal to produce maximum well-being. The trick is defining "maximum well-being."
For many years, social philosophers wrestled with the problem of "aggregation." When we say "maximum well-being" we mean maximum for society. Societies are made up of many people, however, and the problem has always been how to maximize satisfaction, or well-being, for all members of society. What has emerged is the now widely accepted concept of allocated efficiency, first developed by the Italian economist Vilfredo Pareto in the 19th century. Pareto's very precise definition of efficiency is often referred to as Pareto efficiency or Pareto optimality.
Specifically, a change is said to be efficient if it makes some members of society better off without making other members of society worse off. An efficient, or Pareto optimal, system is one in which no such changes are possible. An example of a change that makes some people better off and nobody worse off is a simple voluntary exchange. I have apples; you have nuts. I like nuts; you like apples. We trade, we both gained, and no one loses.
For such a definition to have any real meaning, we must answer two questions: (1) what do we mean by "better off"? and (2) How do we account for changes that make some people better off and others worse off?
The answer to the first question is simple. People themselves decide what "better off" and "worse off" mean. I am the only one who knows whether I am better off after a change. If you and I exchange one item for another because I like what you have and you like what I have, we both "reveal" that we are better off after the exchange because we agreed to it voluntarily. If everyone in the neighborhood wants a park and they all contribute to a fund to build one, they have consciously changed the allocation of resources, and they all are better off for it.
The answer to the second question is more complex. Nearly every change that one can imagine leaves some people better off and some people worse off. If some gain and some lose as the result of a change, and it can be demonstrated that the value of the gains exceeds the value of the losses, then the change is said to be potentially efficient. In practice, however, the distinction between a potential and then actual efficient change is often ignored, and all such changes are simply called efficient.
The Efficiency of Perfect Competition
When dividing up scarce resources among alternative uses, there are three basic questions that all societies must answer.
What gets produced? What determines the final mix of output?
How is it produced? How do capital, labor, and land get divided up among firms? In other words, what is the allocation of resources among producers?
Who gets what is produced? What determines which households get how much? What is the distribution of output among consuming households?
The following discussion of efficiency uses these three questions and their answers to prove informally that perfect competition is efficient. To demonstrate that the perfectly competitive system leads to an efficient, or Pareto optimal, allocation of resources, we need to show that no changes are possible that will make some people better off without making others worse off. Specifically, we will show that under perfect competition (1) resources are allocated among firms efficiently, (2) final products are distributed among households efficiently, and (3) the system produces the things that people want.
Efficient Allocation of Resources among Firms The simple definition of efficiency holds that firms must produce their products using the best available---that is, lowest cost---technology. If more output could be produced with the same amount of inputs, it would be possible to make some people better off without making others worse off.
The perfectly competitive model we have been using rests on several assumptions that assure us resources in such a system would indeed be efficiently allocated among firms. Most important of these is the assumption that individual firms maximize profits. To maximize profit, a firm must minimize the cost of producing its chosen level of output. With a full knowledge of existing technologies, firms will choose the technology that produces the output they want at least cost.
There is more to this story than meets the eye, however. Inputs must be allocated across firms in the best possible way. If we find that it is possible, for example, to take capital from firm A and swap it for labor from firm B and produce more product in both firms, then the original allocation was inefficient.
Efficient Distribution of Outputs among Households Even if the system is producing the right things, and is doing so efficiently, these things will have to get to the right people. Just as open, competitive factor markets ensure that firms do not end up with wrong inputs, open competitive output markets ensure that households do not end up with the wrong goods and services.
Within the constraints imposed by income and wealth, households are free to choose among all the goods and services available in output markets. A household will buy a good as long as that good generates utility, or subjective value, greater than its market price. Utility value is revealed in market behavior. You do not go out and buy something unless you are willing to pay at least the market price.
Remember that the value you place on any one good depends on what you must give up to have that good. The trade-offs available to you depend on your budget constraint. The trade-offs that are desirable depend on your preferences.
We all know that people have different tastes and preferences, and that they will buy very different things in very different combinations. As long as everyone shops freely in the same markets, no redistribution of final outputs among people will make them better off. If you and I buy in the same market and pay the same prices, and I buy what I want and you buy what you want, we cannot possibly end up with the wrong combination of things. Free and open markets are essential to this result.
Producing What People Want: The Efficient Mix of Output It does no good to produce things efficiently or to distribute them efficiently if the system produces the wrong things. Will competitive markets produce the things that people want?
If the system is producing the wrong mix of output, we should be able to show that producing more of one good and less of another will make people better off. To show that perfectly competitive markets are efficient, we must demonstrate that no such changes in the final mix of output are possible.
The condition that ensures that the right things are produced is P = MC. That is, in both the long run and the short run, a perfectly competitive firm will produce at the point where the price of its output is equal to the marginal cost of production. The logic is this: when a firm weighs price and marginal cost, it weighs the value of its product to society at the margin (the current level of an activity) against the value of the things that would otherwise be produced with the same resources. Figure 4 summarizes this logic.
FIGURE 4
The argument is quite straightforward. First, price reflects households' willingness to pay. By purchasing a product, individual households reveal that it is worth at least as much as the other things that the same money could buy. Thus, current price reflects the value that households place on a good.
Second, marginal cost reflects the opportunity cost of the resources needed to produce a good. If a firm producing X hires a worker, it must pay the market wage. That wage must be sufficient to attract that worker out of leisure or away from firms producing other products. The same argument holds for capital and land.
Thus, if the price of a good ends up greater than marginal cost, producing more of it will generate benefits to households in excess of opportunity costs, and society gains. Similarly, if the price of a good ends up below marginal cost, resources are being used to produce something that households value less than opportunity costs. Producing less of it creates gains to society.
Society will produce the efficient mix of output if all firms equate price and marginal cost.
When a firm scale is balanced, it is earning maximum profit; when a household scale is balanced, it is maximizing utility. Under these conditions, no changes can improve social welfare.
Perfect Competition versus Real Markets
So far, we have built a model of a perfectly competitive market system that produces an efficient allocation of resources, an efficient mix of output, and an efficient distribution of output. The perfectly competitive model is built on a set of assumptions, all of which must hold for our conclusions to be fully valid. We have assumed that all firms and households are price-takers in input and output markets, that firms and households have perfect information, and that all firms maximize profits.
These assumptions do not always hold in real-world markets. When this is the case, the conclusion that free, unregulated markets will produce an efficient outcome breaks down. The next few posts discuss some inefficiencies that occur naturally in markets and some of the strengths, as well as the weaknesses of the market mechanism. We also discuss the usefulness of the competitive model for understanding the real economy.
*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 240-245*
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