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(b) Discuss the impact of growing competition on efficiency outcomes. [15]

H1 students to skip the above question.

EJC 2024

Introduction

Efficiency in economics can refer to different types: allocative efficiency, productive efficiency, and dynamic efficiency. Growing competition in markets often has a significant influence on these efficiencies, depending on the nature of the market structure. We will explore the relationship between growing competition and efficiency by comparing market structures such as perfect competition, monopolistic competition, oligopoly, and monopoly. Each structure exhibits varying degrees of efficiency, and the introduction of more competition tends to drive markets toward greater efficiency, though the extent of this effect differs across types of efficiency.

Allocative Efficiency

Allocative efficiency is reached when no one can be made better off without making someone else worse off, typically where the price (P) of a good or service equals its marginal cost (MC). In perfectly competitive markets, firms are price takers, meaning they sell their goods at a price determined by market forces. The condition P = MC is met in the long run, ensuring that resources are optimally allocated to meet consumer preferences.

As competition grows in imperfect markets such as monopolistic competition, oligopoly, or monopoly, firms tend to price their products above marginal cost (P > MC). This creates allocative inefficiency because fewer resources are allocated to the production of certain goods or services than what consumers would prefer. For example, in a monopoly, firms have significant pricing power and restrict output to increase prices, resulting in an inefficient allocation of resources, as fewer consumers are able to purchase the good at the higher price.

However, in markets with growing competition, such as monopolistic competition, firms face pressure to price their products closer to marginal cost. This reduces the degree of allocative inefficiency. In oligopolies, increased competition among firms can also result in lower prices, bringing firms closer to allocative efficiency, although not as perfectly as in competitive markets. For instance, in industries like telecommunications, where oligopolistic competition is intense, firms may lower prices to remain competitive, thereby reducing allocative inefficiencies.

Productive Efficiency

Productive efficiency occurs when firms produce goods or services at the lowest possible cost, which corresponds to the lowest point on the long-run average cost (LRAC) curve. In perfectly competitive markets, firms are forced to be productively efficient in the long run, as they operate at the minimum point of their LRAC curve where marginal cost equals average cost.

In contrast, firms in monopolistic competition and oligopoly may not achieve productive efficiency due to economies of scale, market power, or product differentiation. For instance, firms in monopolistic competition may not fully exploit economies of scale, as they produce differentiated products and are not large enough to reduce costs to the minimum level. Similarly, oligopolies may benefit from economies of scale, but they may not always operate at full productive efficiency due to strategic pricing and profit-maximising behaviours.

However, with increasing competition, firms in both monopolistic and oligopolistic markets may be forced to improve their productive efficiency. As competition intensifies, firms are incentivised to cut costs and optimise their production processes to maintain profitability and market share. For example, in the airline industry, where oligopolistic competition is present, firms have been driven to improve their operational efficiency by reducing overhead costs and adopting more fuel-efficient aircraft to remain competitive. While perfect productive efficiency may not be fully realised, growing competition pushes firms toward lower costs and higher output.

Dynamic Efficiency

Dynamic efficiency refers to a firm's ability to innovate and improve its products or processes over time, which is typically achieved through investments in research and development (R&D). In perfectly competitive markets, dynamic efficiency is often lacking because firms earn only normal profits in the long run, leaving little financial capacity to invest in innovation. Additionally, the absence of entry barriers means that any innovations can be quickly copied by competitors, reducing the incentive to innovate.

In monopolistic competition, dynamic efficiency is similarly constrained. Although firms differentiate their products, long-run normal profits limit their ability to invest significantly in R&D. However, some level of dynamic efficiency may occur as firms compete through product differentiation, driving incremental innovations in product quality or variety to maintain consumer loyalty.

In contrast, firms in oligopoly and monopoly markets have greater potential for dynamic efficiency due to the possibility of earning supernormal profits. These profits provide the necessary resources for substantial investment in R&D, enabling firms to develop new products or improve existing ones. For instance, large technology firms in oligopolistic markets like Apple and Samsung have the financial capacity to invest heavily in R&D, resulting in continuous innovation. Competition in these markets drives firms to innovate further, creating a positive cycle of dynamic efficiency. In monopolies, dynamic efficiency may also occur if there is a threat of potential competition in a contestable market, where firms innovate to maintain their market dominance.

Conclusion

Growing competition generally improves efficiency outcomes in several ways. In terms of allocative efficiency, increased competition forces firms to price their products closer to marginal cost, thus better aligning with consumer preferences. While productive efficiency may not always be fully achieved in imperfect markets, rising competition incentivises firms to cut costs and optimise production processes. Finally, dynamic efficiency is most likely to occur in markets with some degree of market power, such as oligopolies, where firms have the resources to invest in R&D.