The word “efficiency”, in economists’ dictionary, is often interpreted into the degree of an economy allocates scarce resources to meet the needs and wants of consumers. As we can see that a free market economy is the one in which resources are allocated based on the principle of self-interests. Where there are profits, there are firms, and where there are firms to produce identical goods and services, inevitably, there is competition. The degree of competition determines the market structure which is the main determinant of the behaviour or conduct of firms. This in turn determines the efficiency in the use of scarce resources. It is often argued that competition leads to a more efficient use of resources. I agree with the statement, but not totally. In my opinion, competition would lead to efficiency and best use of resource by encouraging firms to improve productivity, to reduce price and to innovate, but in certain industries, particularly industries where the impact of economies of scale is distinctive, for example industries with great indivisibilities, monopoly is more favourable.
Economic efficiency can be seen to maximizing total utility from a given amount of scarce resources. There are two types of economic efficiency—allocative efficiency and productive efficiency. According to their definitions, the idea of allocative efficiency is that “consumers pay firms exactly what the marginal cost is (Price=Marginal cost)…such a pricing strategy can be shown to be a key condition if achieving a ‘Pareto optimum’ resource allocation, where it is no longer possible to make anyone ‘better-off’ without making someone else ‘worse-off’.” (Griffiths and Wall, p93) When this condition is satisfied, total consumer and producer’s surplus are maximized. Alternatively, productive efficiency is about how to produce a good or service. To achieve productive efficiency, a firm must use all available methods to produce a certain level of output at the lowest possible costs.
To start with, a profit-maximizing firm under perfect competition has, first of all, too small the proportion of total industry supply to make any influence on the market price of the identical product. It is therefore a price-taker. As nobody has the power to control the industry, there is complete freedom or no barrier for new firms to enter the industry competing with the existing firms. In this case, the individual firm faces a horizontal demand curve and its AR and MR coincide with the demand curve (shown in figure 1). The firm now is gaining supernormal profit (the shaded area ABPSRPLR) in a short run; as a result, there will be more firms rushing into the industry due to the existence of the supernormal profit. In the long run, the pressure of increasing supply in the industry will push the price at PSR down to the price at PLR where it just equals the lowest level of LRAC, where firms can only get a normal profit for continuing running the business. From the graph, it is easy to see that in the perfectly competitive market, the market price in the long run must be equal to both the firms’ marginal cost and the lowest level of the their long-run average cost. According to the definitions, it is both allocatively and productively efficient. Hence, economic efficiency is achieved. That is, the economy operates at some point on the production possibility frontier—a situation that no one can make itself better off without making others worse off. In other words, “an economy composed entirely by price takers—a competitive economy—automatically allocates resources efficiently, without any need for centralized direction, and it is the power of Adam Smith’s ‘invisible hand’.”(Katz, p410) This is the function of competition, just as Richard pointed out:
“Competition works because people are always trying to get away from it. If its effect is everywhere and always erode away profits, the only...