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Maylorn Thiva 12Au

Are Large Firms More Efficient Than Small Firms? (25 Marks)

A perfectly competitive market has five criteria that it should match. They are as follows, there should be a large number of buyers and sellers, there should be perfect information, they should sell homogenous goods, there should not be barriers to entry or exit and they should be price takers. Economic efficiency is when a firm minimises costs incurred, with minimal undesired side effects. In this essay, I will analyse whether small firms, who exist in perfectly competitive markets are efficient or not. Small firms in a perfectly competitive market can be dynamically efficient. Dynamic efficiency occurs when a firm takes its profits and re-invests them into its production process, this is done to increase their productive efficiency and in order to develop their products. As firms in a perfectly competitive market are price takers, they can become productively efficient by taking existing products and re-investing them into their production process. When they do this, their average costs will go down, and the curve will shift downwards from AC to AC1. With the current market price, they will then earn abnormal profits. Thus the PC (perfect competition) market can be dynamically efficient.
Costs and Revenue Price

Output

Quantity

However, in PC markets, there is perfect knowledge and there are no barriers to entry or exit. So other firms will be able to copy the ideas of the firm, due to perfect knowledge, and they will be able to enter the market, due to freedom of entry. When other firms enter the market, the supply curve shifts rightwards from S to S1 and the market price is then lowered from P to P1, which means the firms new price is P=D=AR=MR1. This means that all firms in the market are back to earning normal profit. Although, as firms will not be able to enter the market straight away, this allows time for the original firm to maintain its abnormal profits. Any new firms that enter the market will not have been earning abnormal profits for that period of time, and thus the initial firms,

Maylorn Thiva 12Au

have an advantage in the sense that they have accumulated a certain amount of abnormal profit. This amount can then be re-invested into the production process again. Productive efficiency involves minimising the average costs of production. To achieve this, a firm must use the factors of production which are available, at the lowest cost per unit. The point on the diagram is where the MC curve intersects the AC curve, as this is the lowest point on the AC curve.

Cost

Output

However, the firm can always innovate and shift average cost to be lower, this will result in the AC curve to shift to AC1. If this happens, and the firm continues producing at its initial output point, then it is no longer productively efficient. This is because, the point at which the MC intersects with AC1 will occur at a different output point, where output will be less. On the other hand, if the firm then repeats the process of using available factors of production, then they can further reduce their average cost and increase output. Eventually, output will have increased to a point where it occurs where the MC curve intersects AC1. Thus the firm is productively efficient again. Allocative efficiency is when the value the consumer pays is equal to that of the cost that is used up in the production process, as in to say, the resources being used are being allocated efficiently. This occurs where the price curve (P) intersects the marginal cost curve (MC). This condition is forced to happen, as producing anything other than what is demanded by the consumer would mean a loss of business for the firm.
Cost and Revenue Price

Output

Quantity

In conclusion, I believe that the perfect competition market structure is economically

Maylorn Thiva 12Au

efficient. As firms in a PC market produce at the point where MC=MR as firms are profit maximisers. This point also matches conditions for different types of efficiency, such as allocative efficiency (P=MC), as P=AR=MR. It also matches the productive efficiency condition (AC=MC), as this point is also where the MC curve intersects the MC curve. The only type of efficiency that does not exactly apply is dynamic efficiency; however, as I have explained earlier, firms in a PC market can be dynamically efficient, although they may choose not to be.