ECO 100 Principles of Economics and Productive Efficiency

What is meant by productive efficiency? How does a perfectly competitive firm achieve productive efficiency? What is meant by allocative efficiency? How does a perfectly competitive firm achieve allocative efficiency? Use a graph to support your answer.

Compare and contract do the price and quantity decision between monopoly market and perfectly competitive industry? 

Productive Efficiency 

Productive efficiency refers to a situation where goods and services are produced with optimal input combination and are associated with lowest cost. In this condition, increase in production of one good requires sacrifice of production of some other good. A point on the production possibility curve is an example of productively efficient point.

Competitive firm and Productive efficiency 

Competitive firms achieve productive efficiency in the long- run. The competitive firms, in the long-run operate at the minimum point of average cost. The productivity efficiency is achieved because of free entry and exit of firms. If firm operates above the average cost then there is supernormal profit, which encourages entry of new firms in the industry. On the other hand, when firm operates below average cost then there is economic loss and then firms exit from the industry. The adjustment continues until all the firms earn only normal profit by producing at the minimum point of average cost. Hence, productive efficiency is reached.

Allocative efficiency is achieved when among different possible production points socially preferred point is chosen. Allocative efficiency represents preference of the consumers and hence is socially optimum production point.

Competitive firm and Allocative efficiency 

In a competitive industry firm’s price equals its unit cost of production. Price of good reflects people’s willingness to for the good and hence is a measure of received social benefit from the good. In absence of any externality, marginal cost reflects the social cost for production of the good. The profit maximizing condition that indicates marginal revenue equals marginal cost reduces to price equals marginal cost for competitive firm. Therefore, the profit maximizing condition for a competitive firm ensures social benefits matches with social cost and hence allocative efficiency is achieved.

In the long run, competitive firm achieves both productive and allocative efficiency (Decker et al.,2017).

Price and output combinations are determined at the point of profit maximization. The profit maximization condition differs in different market depending on feature of the market. The first order condition for profit maximization is unit cost of production should equal to the revenue earned from that unit.

Competitive firm is a price taker in the market. Hence, price equals to the marginal revenue. Therefore, competitive firm chooses profit-maximizing points by equating price with the marginal cost. In figure 3, the competitive firm’s equilibrium point is shown as Ec. Price and quantity for the competitive firm is Pc and Qc respectively.

Monopolist on the other hand is a price maker in the market. The profit maximization condition is equality between marginal cost and marginal revenue. In the figure, Em shows the equilibrium point of operation for the monopolist. Pm is the monopolist’s price and the corresponding quantity is Qm.

From the figure, it is seen that quantity produced in the competitive market is greater than that in the monopoly market. Price in the monopoly market is greater than competitive market. Because of higher price consumer receives lower surplus and producer receives a larger surplus. However, the entire reduced consumer surplus does not transform to producer surplus. There is loss in total surplus in a monopoly market results in a social cost or deadweight loss shown by the triangle.

Inflation in Pakistan

Figure 4 shows the recent inflation trend in Pakistan. The country has made an overall improvement in the inflation status. Earlier both the CPI and WPI recorded a double digit of nearly 11% per annum. Different factors leading to price inflation in Pakistan are a declining g trend of economic growth, a high rate of tax, depreciation of currency and so on. Both demand pull inflation resulted from excess money supply and cost push inflation arising out of increasing cost of production is found to exist in Pakistan. The state Bank of Pakistan sets an inflation target of 5% per annum. The targeted inflation was achieved by 2000 and the price level remained almost stable until 2003. However, price jumped to an excessively high level because of a shortage in agricultural output due to flood in 2010. Thereafter, Pakistan government has taken several steps to reduce inflation rate. The government has relaxed import restriction to maintain a steady flow of important commodities in the nation. In the inflation targeting priority has been given to agricultural sector to stabilize food prices. Additionally, inclusive growth strategy is followed by the government giving special attention to pro poor.

Aggregate demand represents the combined demand for all goods and services in an economy.

AD = C + I +G + (X-M)

C= Consumption expenditure

I= Investment expenditure

G=Government expenditure

X= Export, M = import, (X-M) = net export.

Change in any one component of aggregate demand leads to a shift in the aggregate demand curve.

A fall in export demand will lead to a reduction in export earnings of German. This implies a fall in net export. As a result, aggregate demand falls and there will be a leftward shift in the aggregate demand curve. The initial aggregate demand curve is AD as shown in figure 5.  Real output and price level are determined where aggregate demand and aggregate supply curve intersects. Correspondingly, real output is Y* and price level is at P*. With a fall in export demand, the demand curve will shift inward and the new demand curve is AD_1.  A decline in aggregate demand leads to a decline in both output and price. Output reduces from Y* to Y_1.  Price level reduces from P* to P_1.  Therefore, both real output and price declines with a decline in export demand.

References

Decker, R., Haltiwanger, J., Jarmin, R. S., & Miranda, J. (2017). Declining Dynamism, Allocative Efficiency, and the Productivity Slowdown.

Kirzner, I. M. (2015). Competition and entrepreneurship. University of Chicago press.