Microeconomics 101: Economics Essay

This essay discusses the concept of efficient market structure and compares and contrasts the perfectly competitive model with monopoly in the market place. It covers topics such as allocative efficiency, productive efficiency, technological efficiency, externalities, price discrimination, and innovation.

Running head: MICROECONOMICS 101
Microeconomics 101: Economics Essay
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MICROECONOMICS 101
What is meant by an efficient market structure and compare and contrast perfectly
competitive model with monopoly in the market place?
Perfect competition is a market structure dominated by many firms. There is a large
number of buyers and sellers, free entry and exit of firms, homogeneous product that have
perfect mobility of factors of production and perfect knowledge (Gans, King & Mankiw,
2014). Profit maximization is the goal of the producer where the firm produces the output at
Q1 with equilibrium price at Pe such that AR=MR, also the demand and supply are in line
with the price equilibrium (Pe). The efficiency quotient lies because at Q1 diseconomies is
the same as economies of scale (P=AR=MR=AC=MC) and there is no excess capacity and
there is perfect allocation of resources with normal profits in long run (Carlton & Perloff,
2015)
Figure 1: Efficient market structure
Source: (Ten Kate, 2016)
The economic efficiency quotient can be measured based on the three primary
parameters of efficiency that is, allocative efficiency, productive efficiency and technological
efficiency (Färe, Grosskopf & Lovell, 2013).

MICROECONOMICS 101
For allocative efficiency, the market structure should fulfil two criteria’s one is
Marginal social benefit is equal to marginal social cost (MSB = MSC) and price and marginal
cost should be equal (P = MC) (Waldman & Jensen, 2016). Then for productive efficiency,
the resources should be optimally utilized which can be well depicted by production
possibility curve (PPC) and lastly technological efficiency is achieved when each firm in the
industry produce at the minimum of Average Total Cost (ATC) Curve (Becker, 2017). When
comparing the market structure for perfectly competitive market and monopoly, the economic
efficiency can be achieved if all the three efficiencies are fulfilled.
Allocative efficiency is where goods are distributed among consumer preferences
such that in the above diagram of perfect competition, in the firm part, at Q1 quantity
demanded where, Pe=MC. In the industry part, its enclosed by demand and supply curve with
Pe price and Q1 quantity demanded. The point of perfect allocation will be achieved where
the consumer surplus will be equal to producer surplus. However, in monopolies, it is said to
be allocatively inefficient because the price is above the marginal cost (Scitovsky, 2013). On
the contrary, in perfectly competitive market, the firm produces where marginal social benefit
(MSB) is equal to marginal social cost (MSC), but as the monopoly curve does not has a
supply curve, the MSB = MSC is not true for monopoly. In addition, monopolies have market
power which diminishes the consumer surplus and makes them earn supernormal profits as
shown in figure 2.

MICROECONOMICS 101
Figure 2: Allocative inefficiency in Monopoly
Source: (Scitovsky, 2013)
Mathematically, allocative efficiency can even be studied using Pareto Optimality
where by describing specific levels of consumptions for a consumer can be determined with
specific input with each producers output level. Although, pareto optimality is the basis for
welfare economics but it cannot be used to increase the utility of an individual without
decreasing the utility of others. Nevertheless, if individually in perfectly competitive market,
the rate of consumer substitution (RCS) is analysed for a pair of goods on a price ratio, it can
be given as:
RCSjk = pj/ pk (where j and k are commodities/ factors)
However, when the firms are profit maximisers then,
RPTjk (Rate of product transformation) = pj/ pk
MPjk (Marginal Product) = pj/ pk (Both j and k refers to factors)
RPTjk = RCSjk. (Hence, as per the condition, pareto optimality is seen in perfectly
competitive market) (Henderson & Quandt, 2013).
On the contrary, if prices were not equal to Marginal Cost then prices are proportional
to MC. Equating in terms of pi/ pj = (1/ θ)*MPij ; pi/ pk = (1/ θ)*MPik (j and k commodities and
i is factor). Therefore, perfect competition characterizes to be a welfare ideal for requirements
of Pareto optimality if the assumptions are not violated. It cannot be said the same for
imperfect competition or monopoly because in commodity market or factor market it does
not satisfy the optimal resource allocation,
MP = r/p = RCS

MICROECONOMICS 101
p = r/ MP = MC
p * MP = r, this equation does not satisfy for one or more sellers making it pareto
nonoptimal for the monopoly market structure (Henderson & Quandt, 2013).
On the other hand, productive efficiency is the optimal combination of the goods
produced with the inputs to produce maximum output for the minimum cost. Productive
efficiency can be explained with production possibility frontier (PPC) where loss of output on
one good leads to gain of output of other (Stryk, 2013).
Figure 3: Production Possibility Curve
Source: (Pindyck & Rubinfeld, 2015)
Diagrammatically in figure 3, it can be explained that point A is productively efficient
whereas B and C are productively inefficient because more of goods and services can be
utilized with no opportunity cost. Based on the analysis of market structure, perfect
competition is productively efficient where AC is at its minimum whereas the same cannot be
said for monopoly (Waldman & Jensen, 2016).
Thirdly, technological efficiency can be stated in two ways whether with given the
output produced, the costs of production are minimized or whether given the costs of
production, the output is maximized. In perfectly competitive market, the firms are producing

MICROECONOMICS 101
on their cost curves and all the firms wishes to minimize the costs so that the profits are not
maximised. In addition, the perfectly competitive market gives zero profit in the long run.
However, profit in the industry are producing at the minimum point on ATC to not be driven
out of business in long run by its efficiently placed competitors (Pindyck & Rubinfeld, 2015).
Whereas in a monopoly, the firms are not producing on their cost curves because a
monopoly operates on minimizing costs and increasing profits and the industry is even not
producing on the minimum point on the cost curve ATC because the Pm >AC. Hence, its
producing too little at a high price (Zeuthen, 2018).
According to the comparisons between perfectly competitive market and monopoly,
the perfectly competitive market is efficient because they have the least market power and
yield the efficient outcome whereas the same cannot be said for monopoly. Monopoly is a
“Price Maker” and deals with one commodity whereas perfectly competitive market is a
“Price Taker” and deals with homogeneous products (Waldman & Jensen, 2016). In the
actual world perfect competition is a myth but there is prevalence of perfect competition in
agriculture and local farm products where there are many fruits and vegetables sold at the
same price with no competition at all.
However, there are certain exceptions to the analysis that needs to be examined
because there are times when the perfectly competitive market cannot be as efficient as
understood and monopoly cannot be inefficient as presumed (Kirzner, 2015). There are
exception of both types that can be described additional to the given analysis. When in terms
of contestable markets, it has single or less firms which produce a product with no close
substitutes and there is no competition from other firms (Mahoney & Weyl, 2017). Also, it
keeps the costs under control with minimum wastage of the resources and even from further
exploitation of the consumers by setting high prices and gaining from its profit margins. As a
result, there are no barriers to entry, that is, entry and exit are cost free and exhibits level of

MICROECONOMICS 101
economic efficiency in long run (Page, 2013). Hence, a monopoly will not raise its price to its
monopoly price because there is no threat for the competition that exists.
Externalities, can be other point, where the exchange happening between buyer and
seller can be affected to the third party whether negatively or positively. In regards to positive
externality, the third party has gained from the exchange because there is no demand curve
but only private advantage of the product (Okun, 2015). In this case, MSB exceeds the
demand curve. In contrast to this, negative externality is when the third party has suffered
loss from the exchange because the cost is not equal to the supply curve as it only includes
the costs of production of the product to the sellers making marginal social cost higher than
supply curve. When analysed from the perspective of allocative efficiency in perfectly
competitive market, there will be misallocation of resources such that there will be less
output at a low price (positive externality) or more output at a low price (negative externality)
(Pindyck & Rubinfeld, 2015).
A monopolist can charge different price from different customers. The maximum
price which a consumer is willing to pay is knows as Reservation Price. This happens
because cost of production differs. For example, the people who go to see a movie in a
matinee hall will be charged a lower price than the people who go to see a movie in a
multiplex. This helps in increasing the efficiencies of monopoly and is done on the basis of
people who wish to give away their consumer surplus (Waldman & Jensen, 2016).
Alternatively, natural monopoly termed as monopoly of a firm can price the entire
output of the market at a cost lower than other several firms. This kind of monopoly arises
due to strong economies of scale. A single large firm always has lower average costs than do
smaller firms, the larger firm will always be able to drive out smaller, less cost-effective,
competitors (Hayek, 2016). A monopolized industry will be the natural result of this process.

MICROECONOMICS 101
Economies of scope arise in terms of a single situation when one good is profitable and other
is not and both can be produced at lower average cost than the other small competitors
(becker, 2013). The scope of production, in contrast to the scale of production, prefers not to
increasing the quantity produced but to increasing the number of products produced by the
firm. For example, railways, hospitals, etc.
Price discrimination is other factor where a different price is charged to a different
customer even though the cost of production remains the same (Pigou, 2017). This is one
exception that supports monopoly’s efficiency based on three requirements – one is that the
firm should have some market power not importantly a monopolist but not even a perfectly
competitive firms; second firms must be able to separate the market in two groups at least to
identify the group who will pay higher or lower and third is reselling of the products are
important. However, if perfect price discrimination is considered then a minimum of two
groups have been made upon knowledge. In this case, when discriminating price, marginal
revenue will be equal to demand because the price charged to first customer would be the
same irrespective of the price to the following customers (Weyl & Fabinger, 2013).
Diagrammatically in figure 4, P = MR and P = MC creating allocative efficient output.
Figure 4: Perfect Price Discrimination

MICROECONOMICS 101
Source: (Pigou, 2017)
If innovation has to take place, technology will change. As a result in perfectly
competitive market, if technology changes, profit will rise and entry will occur and even if it
tries to gain it zero profit situation, there will be no incentive to innovate whereas in
monopoly if innovation happens, price rises with barriers to entry, price rises and there will
be incentive to innovate (Waldman & Jensen, 2016).
From all these points, a conclusion can be derived that a perfectly competitive market
is efficient in terms of allocative and technological efficiency with least market power but on
the other hand, keeping all the exceptions in mind with the constraint of barriers to entry a
monopoly can achieve technological efficiency. Although, when it comes to productive
efficiency, a perfectly competitive market do not use its resources to the fullest while giving
maximum services whereas in monopoly it can happen in terms of innovation and price
discrimination. One can see the prevalence of a monopoly through railways in railroad
transportation, government control of nuclear power, state electricity board monopoly over
generation and distribution of electricity in all states.

MICROECONOMICS 101
References
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Pearson Education Limited.

MICROECONOMICS 101
Scitovsky, T. (2013). Welfare & Competition. New York: Routledge.
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Available at SSRN: https://ssrn.com/abstract=2740523 or
http://dx.doi.org/10.2139/ssrn.2740523
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