WHY in allocative efficency p=mc=mr
In allocative efficiency, the condition for maximizing social welfare is that price (P) equals marginal cost (MC) equals marginal revenue (MR). This condition is derived from the understanding of marginal analysis in microeconomics.
To understand why P = MC = MR in allocative efficiency, let's break it down step by step:
1. Marginal Cost (MC): MC is the additional cost incurred by producing one more unit of a good or service. It represents the cost of the resources (such as labor, materials, and equipment) required to produce that additional unit. MC is typically upward sloping because, as output increases, additional resources are needed, resulting in higher costs.
2. Marginal Revenue (MR): MR is the additional revenue gained by selling one more unit of a good or service. It represents the change in total revenue resulting from the sale of that additional unit. For firms operating in perfectly competitive markets, MR is equal to the price of the good because they are price takers and cannot influence the market price.
3. Profit Maximization: In a perfectly competitive market, firms aim to maximize their profits. They will continue to produce and sell more units as long as the marginal revenue obtained from the additional unit is greater than or equal to the marginal cost of producing that unit.
4. Allocative Efficiency: Allocative efficiency occurs when the market equilibrium is achieved, meaning the quantity supplied equals the quantity demanded at a particular price. Efficient allocation means that resources are being allocated in a way that maximizes social welfare.
Now, putting these concepts together:
In allocative efficiency, the market equilibrium occurs when P = MC. This condition ensures that the price reflects the marginal cost of production. If P is higher than MC, firms would have an incentive to produce more since they can sell each unit at a higher price than it costs to produce. This would increase social welfare as long as the marginal benefit to consumers is still higher than the marginal cost to firms. However, if P is lower than MC, firms would not have an incentive to produce since they would incur losses on each unit sold. In this case, social welfare would be maximized by reducing production to the point where P = MC.
Additionally, since firms in perfectly competitive markets are price takers, they can only sell additional units at the market price. Therefore, MR is equal to P. Hence, P = MC = MR in allocative efficiency.
In summary, in allocative efficiency, the equality of price, marginal cost, and marginal revenue ensures that resources are efficiently allocated, and firms are maximizing their profits while providing goods and services at the socially optimal level.