In long-run competitive equilibrium, production adjusts to changes in Demand, or

Question

In long-run competitive equilibrium, production adjusts to changes in Demand, or the availability of new technologies primarily through the entry or exit of firms to the industry. a. What two types of efficiency will be required of firms in order to survive in this industry? b. Identify the criteria (MC = minimum ATC, and P = MC), for each type of efficiency mentioned in (a). c. Describe how the market conditions of competition and entry/exit produce both types of efficiency in the firms operations and in the market in accordance with these two criteria. d. How are these two criteria related to the workings of the invisible hand.

Explanation / Answer

a. The two types of efficiency that will be required of firms to survive in a competitive industry are:

Allocative efficiency: It means that resources are used for producing the combination of goods and services most wanted by society. For example, producing computers instead of manual typewriters.

Productive efficiency: The least costly techniques are used to produce wanted goods and services.

b. Productive efficiency occurs where price is equal to minimum average total cost (min ATC). At this point, firms use the least-cost technology or they wouldn’t survive. This outcome is achieved as long as the long-run equilibrium price would be at the minimum ATC.

Allocative efficiency occurs when price is equal to marginal cost (P=MC) because price is society’s measure of relative worth of a product at the margin or its marginal benefit. And the marginal cost of producing the product measures the relative worth of the other goods that the resources used in producing an extra unit of the product.

c. In the long-run, firms are attracted into the industry if the incumbent firms are making supernormal profits. This is because there are no barriers to entry, and the effect of this entry is to shift the industry supply curve rightward, which drives down the price until the point where all supernormal profits are exhausted. If firms are making losses, they will leave the market as there are no exit barriers. This will shift the supply curve leftward, raises the price and enable those left in the market to derive normal profit.

d. According the invisible hand theory, each of us, acting in our own self-interest, generates a demand for goods and services that compels others to deliver those goods and services in the most efficient manner, and resources are allocated in the most efficient way. This invisible hand theory described by Adam Smith is broadly accepted even today as a means to explain the forces of a free market economy.

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