BUSINESS ECONOMICS2Answer 1Answer a Allocative EfficiencyAllocative efficiency refers to the choice of production points on the productionpossibility curve such that the points are socially preferred. Perfectly competitive firm is taken asa benchmark for allocative efficiency. In perfectly competitive market, the price that prevails inthe market always equals to the marginal cost of production. For a particular good price is usedas a signal for social benefit. The marginal cost on the other hand not only represents cost ofseller but is also a representative measure social cost of the good (Fine, 2016). By following theprofit maximizing rule of price equals marginal cost competitive firms ensure allocativeefficiency.Perfectly competitive market and allocative efficiencyIn a perfectly competitive industry, all the firm in the long run can enjoy only a normalprofit. Suppose a competitive firm in the long run is enjoying a supernormal profit. It thenencourages other firms to enter the industry. Entry of new firms continue until only normal profitis left in the industry. During economic loss, firms leave the industry (Baumol & Blinder, 2015).The long run equilibrium holds where price equals minimum average cost which also equalmarginal cost.
BUSINESS ECONOMICS3Figure 1: Allocative efficiency in perfectly competitive market(Source: as created by Author)Answer bAllocative inefficiency in monopolistically competitive market In a monopolistically competitive market allocative efficiency does not achieve either inthe short run or in the long run. Firms in the monopolistically competitive market follow theprofit maximization rule as marginal revenue equals marginal cost. Unlike perfectly competitivemarket, firm face a downward sloping demand curve. The marginal revenue thus is not equal tothe price. As price is greater than marginal revenue, it is also higher than marginal cost. Whenprice exceeds in marginal cost, benefits that society gets from additional unit of output reflectedin the price exceeds the social cost of providing the good (Moulin, 2014). In the long run, firmsthough have only normal profit but still output is less than socially efficient outcome. Thesocially efficient outcome corresponding to minimum point of average cost. Monopolisticallycompetitive firm in the long run operates to the left of minimum of average cost. There exists an
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