QUESTION 1:Discuss, using examples and academic references, the statement that perfect competition gives an optimal allocation of resources but that the existence of scale economies may make perfect...

Question: Discuss, using examples and academic references, the statement that perfect competition gives an optimal allocation of resources but that the existence of scale economies may make perfect competition impossible##########words).
Solution: We can study the above statement in two parts:
1. In perfect competition we have efficiency which means optimal allocation of resources
2. Economies of scale may make perfect competition impossible
Perfect competition implies efficiency
Perfect competition is a market structure which is based on very heroic assumptions and the assumptions are very - very strong and highly unlikely to exist. In case of non-existence of economies to scale, perfect competition is considered to be ideal form of a market structure from point of view of consumers and society.
The assumptions lead to pure competition with perfect flow of information. The heroic assumptions behind perfect competition are following:
1. Large number of small firms present in the market, their size is i
elevant to market none of the firms have control over the market price
2. Large number of individual consumers, none of the consumers control the prices in the industry
3. Free entry and exit, no restrictions and ba
iers to entry and no penalties on exit of the firm from the market
4. The products are perfectly homogeneous and perfect substitutes. Which leads to perfectly elastic demand curve for each firm
5. Perfect flow of knowledge and knowledge available to both sellers and customers at zero cost
6. No production and consumption externalities
In short run, an individual firm under perfect competition earns supernormal profits and in long run due to free entry and exit more and more firm will be attracted towards market because of the supernormal profits. And in long run supernormal profits will decline to normal profits.
The figure below describes this:
As a perfect competitive firm is price taker, it does not have any say in deciding the price. So, its average cost curve coincides with the marginal revenue curve. And it faces a horizontal demand curve. And its demand curve is its average revenue curve. In the short and as well as in the long run take a non changing demand curve. In the short run, we have supply curve as MS, and market price is P1, where for each firm Price = Marginal Cost. The firm is producing at price P1 with Q1/number of firms output for each firm. In the long run more and more firms enter into market and supply curve shifts downwards to MS2 and in long run, price will go down to P2 and equili
ium output will increase to Q2. As the firm is price taker the price will decline to P2 and firm’s output will increase to Q3.
An optimal allocation of resources means all kind of efficiency is achieved and there are no deadweight losses. Perfect competition achieves three kinds of economic efficiencies:
1. Allocative efficiency: At equili
ium, both consumer surplus and producer surplus are maximized and we have a Pareto optimal situation i.e. no one can be made better off without making someone worse-off
2. Productive Efficiency: this implies lowest possible cost with highest possible output in equili
ium. Firms are producing the highest possible output at lowest possible cost.
3. Dynamic Efficiency: No scope of innovation because of homogeneous products and no scope of monopoly. As the firms are very-very small compared to market. They cannot incur cost of innovation and advertising. So, the dynamic efficiency prevails.

In the figure above, we can see that if we have market structure as perfect competition then total of producer surplus and consumer surplus is ABC and equili
ium output and price are Q1 and P1 respectively. But when we have any market structure other perfect competition where profit maximization condition is MR = MC , then total of producer surplus and consumer surplus decline to ABDE and equili
ium quantity will decrease to Q2 and equili
ium price will increase to P2. A totally win-win situation for the firm, but not for the society and the consumer.
Economies of scale may make perfect competition impossible
The major argument one gives in favour of the perfect competition is that in it prevails, efficiency and due to higher number of firms and customer higher output and lower prices. Another argument is that whenever there is a monopoly, then because of its profit motif it will charge higher price and produce less and try to maximize its profits. But if economies of scale are present...