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IAI Actuarial Core Principles · Business Economics · How competitive markets operate

Which condition describes allocative efficiency in a competitive market in terms of surplus?

Allocative efficiency holds when price equals marginal cost, meaning the value placed on the last unit by consumers equals the cost of producing it. At that output total surplus is maximised and no further mutually beneficial trades remain.

  1. AProducers earn the maximum possible profit on each unit
  2. BConsumer surplus is greater than producer surplus
  3. CThe price equals the marginal cost of production, so total surplus is maximisedCorrect
  4. DOutput is produced at the lowest point of the average total cost curve in the short run
  5. The government sets the price to equalise buyers' and sellers' surplus

Explanation

Allocative efficiency occurs where the value to the marginal consumer (price on the demand curve) equals marginal cost, which maximises total surplus. Option D describes productive efficiency, a different concept. The relative sizes of the two surpluses (B) do not determine efficiency.

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