There are three conditions that determine efficient market conditions. These are the marginal rate of substitution (MRS) of two commodities, the marginal rate of technical substitution (MRTS) between the two factors, and the marginal cost of producing a good. In order to meet these conditions, the resources in the market must be distributed in the most economical way possible.
The marginal cost of production represents the social costs of producing a good. If a good’s price is higher than the marginal cost, then the product is inefficient. On the other hand, if the price is lower than the marginal cost, then the product is efficient.
A perfectly competitive firm maximizes its profits by achieving an efficient quantity of production in which the price of the good equals its marginal cost. In order to do this, all firms must have the same marginal rates of technical substitution.
However, the firm may not always set its price at the marginal cost. This is called allocative efficiency.
The condition of Pareto efficiency, or Pareto optimality, is an economic situation where all resources are allocated to achieve the highest amount of productive efficiency. It is measured along the production possibility frontier.
Specifically, the marginal cost of the good X relative to the good Y must be the same for all consumers. Also, the marginal rate of substitution between the two commodities must be the same. When the MRS of two goods is the same for all consumers, then the products are Pareto efficient.