Efficiency means more than just producing in the least cost manner. To be efficient a market must also allocate the right amount of resources towards the production of the good or service it provides. Allocative efficiency occurs when land, labor and capital are allocated towards the production of goods and services in combinations that are socially optimal. In other words, the right amount of output of various products is being produced given the demands of consumers in the economy and the costs faced by firms.
Because of firms’ profit maximizing behavior, perfectly competitive markets allocate resources efficiently, neither over nor under-producing the goods consumers demand.
Allocative Efficiency: P=MC
Under the conditions of perfect competition, a market will be allocatively efficient as long as the firms in that market produce at the P=MC level of output. Price is a signal from buyers to sellers, and the price seen by firms signals the marginal benefit of consumers in the market. If the price consumers pay for a product is greater than the marginal cost to firms of producing it, then the message being sent to producers is that more output is demanded. In the pursuit of profits, more resources will be allocated towards the production of the product until the marginal cost and the price are equal. At the P=MC point firms maximize their profits and resources are said to be efficiently allocated.
Graph: Profit maximizing behavior leads to allocative efficiency
Assume that the firm on the right represents the typical firm in a perfectly competitive market. When firms produce at Q1 level of output, resources are under-allocated towards this good, since the price consumers are willing to pay (Pe, determined by market supply and demand) is greater than firms’ marginal cost of production. Notice that when individual firms produce Q1 units, the market supply of Qs is less than the market demand of Qd; there is a shortage in the industry as long as firms produce only Q1 units.
However, firms are unlikely to produce at this socially undesirable level for long because in their pursuit of profits they will increase their output to the quantity at which marginal cost equals the price. When they increase their output to Qf, firms maximize their profits and as a result the shortage in the market that existed when firms produced at Q1 is eliminated, improving social welfare and maximizing the total amount of consumer and producer surplus (the combined areas of the pink and green triangles in the industry graph).
Because of the profit maximizing behavior of self-interested business managers in the competitive market above, resources are more efficiently allocated than they would be otherwise. The price determined by supply and demand in the market signals the benefit society derives from this good, and as long as the price is greater than the marginal cost, the message sent from buyers to seller is “WE WANT MORE!” On the other hand, if at a given level of output marginal cost exceeds the price, resources are over-allocated towards the good. The message sent in such a market is that consumers value the product less than it costs firms to produce, so firms will reduce their output to maximize profits, correcting the over-allocation of resources and restoring a socially optimal level of output.
Allocative efficiency is achieved in a perfectly competitive market precisely because firms will always wish to maximize their profits by producing the quantity of goods at which their marginal cost equals the price.
The article Farmers May Switch Crops Due to Labor Shortage discusses some the effects of rising costs on a perfectly competitive market. Read the extract below and answer the questions that follow.
Farmers may change their crops due to the shortage of immigrant labor. Of all crops, fresh fruits and vegetables are the most labor intensive. Lettuce, strawberries and broccoli all have to be picked by hand. In Arizona, farmers are passing on chili peppers to plant corn, which is harvested by machine.
After 37 years, Ed Curry is not planting green chili anymore because corn can be harvested by machines; green chili can’t.
Curry explains, “It would take about 250 people to pick this year’s chili crop. With immigration tightened up the way it is, well, number one, we just can’t get the labor.”
About seven years ago, Ed Curry was busted for using illegal labor. Today his workers are legal. They go back and forth from Mexico each day, making seven to $8 an hour. Most are in their 50s and 60s. One man is 72 years old. Younger workers can’t get visas or don’t want the jobs. So as his workers age and his workforce dwindles, Ed Curry says he’s thinking about moving some of his operation to Mexico.
“We’re down to survival. Am I going to stay in this or not? And if I’m going to stay in it, I’ve got to do it where there’s plenty of labor and we can be competitive.”
That’s one farmer’s plight. The Western Growers Association based in California represents 3,000 farmers across the region. Its president, Tom Nassif, says farmers need Congress to pass legislation that will allow more workers in, something he says it should have done already.
Nassif says his association polled a dozen members and found more than 40,000 acres had moved to Mexico in the last year or so.
- Assuming the market for chili peppers is perfectly competitive, illustrate the effects of the shortage of immigrant workers on the short-run production costs and profits of chili farmers in the American Southwest.
- Based on your answer to #1, explain how the chili market will evolve in the long-run in response to the shortage of immigrant workers. How will the market for corn and other capital-intensive agricultural commodities be affected?
- Assume the US chili pepper market reaches a new long-run equilibrium following the shortage of immigrant labor. Now demand for chili peppers increases. Use a diagram to illustrate how the profit maximizing behavior of chili pepper farmers assures that there will not be a shortage of chili peppers following the increase in consumers’ demand.
Discussion Questions: In their pursuit of economic profits, firms in a competitive market will, through their collective pursuit of self-interest, inadvertently achieve an allocation of society’s scarce resources that is socially optimal.
- Discuss the view that allocative efficiency as defined in this chapter is a socially desirable outcome.
- Is it accurate to say that goodness can be achieved through greediness in a market economic system?