Explain Why Perfect Competition Might Be Expected to Result in an Allocation of Resources Which Is Both Productively and Allocatively Efficient. (20 Marks)

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Explain why perfect competition might be expected to result in an allocation of resources which is both productively and allocatively efficient. (20 Marks)

Perfect competition can be used as a yardstick to compare with other market structures because it displays high levels of economic efficiency. Allocative efficiency occurs when there is an optimal distribution of goods and services. This involves taking into account consumer’s preferences. In both the short run and the long run in perfect competition we find that price is equal to the marginal cost (P=MC) and thus allocatively efficient is achieved. At the ruling market price, consumer and producer surplus are maximised. However, no one can be made better off without making some other agent at least as worse off. At the point where the price meets the marginal cost, allocatively efficient occurs assuming prefect competition is present. At the point P=MC resources are being used as efficiently as possible. A perfect competition market has many key features. One of these features is that every firm is a price taker, meaning they cannot set the price. This causes businesses to be efficient as the most efficient competitor or they will be out-priced. This results in inefficient firms going out of the business whilst the most efficient businesses stay alive.

If most firms are making abnormal profits, this encourages the entry of new firms into the industry, which if it happens will cause an outward shift in market supply forcing down the ruling market price, as shown on the left graph. This increase in supply will eventually reduce the market price until price = long run average cost. At this point, each firm in the industry is making normal profit. Here firms operate at the minimum average total cost as they are producing the maximum possible output from inputs into the production process. If most firms are making abnormal profits, this encourages the entry of new firms into the industry, which if it...
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