A Final Overview: Economic Efficiency Models and Properties

Abstract

AbstractThe canonical model of perfect competition, resulting in social welfare maximization, assumes all kinds of technical and allocative inefficiencies away. In equilibrium, economic theory establishes that in contestable markets, competition forces draw firms towards profit maximization (Vickers, 1995). This in turn requires that, on one hand, firms exploit the existing technology at its full, so there are not engineering failures in the production of goods and services, while, on the other hand, optimal input and output amounts are, respectively, demanded and supplied according to their relative market prices. In any neoclassical microeconomics textbook, right after discussing production theory and cost minimization (normally in separate chapters), the chapter on profit maximization and competitive supply describes the adjustment processes towards short-run and, through entrants and exiters, long-run equilibria. This process is related to the evolutionary notion of competitive selection. However, it is self-evident that, at one moment in time, the forces behind the stylized postulates of competitive markets are far from being observed in real life, failing to discipline suboptimal behavior, and ensuring that inefficient firms are driven out of the industry. The mounting evidence published in the general media and academic journals confirm that economic inefficiency originating from technical and allocative inefficiencies is pervasive across markets. Economics rationalize this reality by doing away with the postulates of perfect competition and entering market failures, most notably the existence of imperfect conditions associated with market power, differentiated products, or imperfect information, which result in firms being price setters rather than price takers. All these factors would allow inefficient firms to survive in the market, even if they are not economically efficient, either in technological or allocative terms.