Perfect Competition Issues - Essay Example

?Microeconomics Answer Perfect competition is a market structure in which there are infinite firms and infinite number of buyers. Firms are price takers since they have a small market share. In this market, firms enjoy normal profit and price is equal to average revenue. This market structure is considered as a benchmark for making comparisons with other market structures, since it displays high levels of economic efficiency. Allocative efficiency: In the perfectly competitive model price (P) equals marginal cost (MC). At the price prevalent in the market, both consumer surplus and producer surplus are at their maximum level. No single agent in this economy might be better off without making another agent worse off. This leads to the achievement of allocative efficiency (MC=AR). It is known as “Pareto optimum allocation of resources” (Klein, 2007). Productive efficiency: In the long run, in a perfectly competitive market structure, the output is produced at the lowest level of average total cost. This phenomenon is known as productive efficiency (MC=ATC). The firms that incur high unit cost are inefficient and are not fit to stay in business in the long run. The forces of competition would not allow them to charge high price. Thus, they would be forced to quit industry in the long run. Dynamic efficiency: One important assumption in the competitive market structure is that all producers in the industry produce homogeneous products. Homogeneity of the products ensure that the products are similar in features and attributes and any single firm would not have the facility to make any innovation such that it would make the products of the firm to differentiated from the products of the other firms. This creates dynamic efficiency. No single firm would be able to enjoy competitive advantage over the others or enjoy any degree of monopoly power. Figure 1: Efficiency in perfect competition (Source: Author’s creation) Answer 2. Monopolistically competitive market refers to a market framework in which there are many producers and many buyers. The goods produced by these producers are very similar in attributes and act as close substitutes for each other. There are two important features in this type of market structure; product differentiation and presence of several firms in the market. Short Run Equilibrium In the short run, equilibrium is achieved at the point at which marginal revenue equals marginal cost. As long as value of marginal revenue (MR) exceeds value of marginal cost (MC), producer would expand output since profit level rises with rise in output (MR>MC, i.e., difference between MR and MC is positive). When marginal revenue is smaller than marginal cost, the producer would reduce output until the two values equate. Thus, in short run, profit maximizing price and output firm is determined at the position where MR equals MC. In short run, firms might earn super normal profit if average cost is less than average revenue, or conversely, they might incur a loss if the average cost is greater than average revenue. Figure 2: Short run equilibrium under monopolistic competitive market structure (Source: Author’s Creation) Long Run Equilibrium In long run, there are scopes of entry of new firms into the industry. Therefore, supernormal profit is erased in the long run. As new firms enter into the industry, demand faced by each firm decreases and Average revenue (AR) curve shifts leftwards. Consequently, supernormal profit falls. Firms would produce at the level at which marginal revenue equals marginal cost and price is determined by the interaction between average revenue and average cost. All firms earn normal profit in the long run. Some firms that incur loss in the short run would leave the industry in the long run and the remaining firms would earn normal profits. Figure 3: Long run equilibrium under monopolistic competitive market structure (Source: Author’s Creation) In case of monopolistic competition, in the long run, firms operate at the zero profit condition, which ensures that price is equal to average total cost. But, it is not assured that price equals marginal cost. In monopolistic competition, firms operate on the falling portion of the average total cost curve, which shows that the marginal cost is below average total cost. Therefore, price is above average total cost. Price is also above marginal cost of production, since each firm enjoys a market power. Higher the market power, greater is the difference between price and marginal cost. These firms do not achieve allocative or productive efficiency. From the point of view of the society, there is a deadweight loss. Due to the mark-up of price, some customers would be deterred from buying the product. These customers value the good above the marginal cost, but below the price charged. This implies a significant loss in economic well-being to society in these markets (Mankiw and Taylor, 2006). Answer 3. Natural monopoly is a type of monopoly market structure. In this market structure, there exists a huge scope for exploiting economies of scale. The benefits of economies of scale are enjoyed by the firm only if the firm produces a large quantity of output. Thus, natural monopoly is a market structure in which monopoly is created by the size of the market. If there are many firms, market share would be divided and there would not be scope for each firm to produce at a higher level of output. Since the scale of production at which the firm might enjoy economies of scale is a high proportion of total market demand, production of this level of output requires large infrastructural set up and raw materials. Therefore, entry is barred. Only a single firm has the chance to produce the entire output demanded by the market at the lowest cost. In case of natural monopoly, regulatory authority is necessary to set the price of the product that that would prevail in the market. This price would be the first bets price and would be equal to marginal cost. This would assure that maximum social welfare is achieved (Hutcher, 2011). In most cases public utilities are good example of natural monopoly; in this case state regulation is important to avoid the dead weight loss, so that all individuals in the society are capable of accessing these goods or services. In the following diagram it is shown that after price regulation is implemented, price falls to P1 and output increases to Q1. Figure 4: Natural monopoly and price regulation (Source: Author’s creation) Answer 4. (a) Every economic activity or decision taken by producers or consumers casts an impact on the other members of the society that are not directly linked with the activity or decision. If the effect is positive, it is termed as positive externality and if the effect is negative (i.e., if costs are incurred by the other members of society), it is termed as negative externality. Positive externality includes public facilities provided by government or investments in R&D. Pollution, deforestation and congestion are some examples negative externality. (b) Negative externality correction and government intervention In order to assess the social welfare generated by various production and consumption decisions made by economic agents, economists calculate the private costs and benefits and compare them with social costs and benefits. Government intervention is necessary to make the decision maker internalize the social cost of the decision, i.e., the creators of externality must realize the impact of the externality before creating them. Examples of government intervention include, pollution tax, congestion charge and environmental tax such as, landfill tax and plastic bag tax and road tax. Figure 5: Correcting negative externality by government intervention (Source: Author’s creation) The difference between marginal propensity to consume (MPC) and marginal social benefit (MSB) represents the negative externality. When government imposes taxes MPC curve shifts upwards and level of consumption falls from Q1 to Q2 which is closer to Q* (which is the output level that maximizes social benefit). Answer 5. (a) The Australian government has changed its focus of industry policy dramatically over the period of last 20 years. Attention has been shifted from protection to increasing level of competition. This change has taken place through actions such as, removing uneven tax rates, price controls, revising product designs and promoting micro-economic reforms for bringing structural change in some particular industries. The health care industry reflects a significant reform. This reform is considered imperative for the smooth running of the Australian economy in the highly competitive global marketplace. (b) “Private health insurance” (ADF, n.d.) represents one of the most risky markets in Australia and absorbs almost 9 percent of the country’s total resource endowment. In financial year 2005-2006, the Australian Government decided to bring reforms in the private health insurance industry. As a result, the existing policies were revised. The reform aimed at improving competition, providing value to customers and as a whole assuring stability and sustainability of this sector (Shamsullah, 2011). It has been found through research that the reform actions have been successful in improving the performance of the firms in this sector (OECD, 2003). In the health insurance sector, reforms have been able to increase allocative efficiency by changing the price structure in the industry. Price has been set to equal marginal cost of the services offered (Health, 2006). This allows the consumers’ surplus as well as the producer surplus to increase (Deloitte, 2011). Reference List ADF, n.d. Microeconomic Reform of the Australian Private Health Insurance Industry (A Synopsis). [online] Available at: < http://www.adf.com.au/archive.php?doc_id=106 > [Accessed 17 September 2013]. Deloitte, 2011. The Impact of Health Reform on the Individual Insurance Market: A strategic assessment. [pdf] Available at: < http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/Documents/Health%20Reform%20Issues%20Briefs/us_chs_HealthReformAndTheIndividualInsuranceMarket_IssueBrief_101011.pdf > [Accessed 17 September 2013]. Health, 2006. Key Strategic Directions for 2005-06. [online] Available at: < http://www.health.gov.au/internet/annrpt/publishing.nsf/Content/strategic-directions-0506-8 > [Accessed 17 September 2013]. Hutcher, P., 2011. Theory of natural monopoly. Munich: GRIN Verlag. Klein, A., 2007. Comparison of the models of perfect competition and monopoly under special consideration of innovation. Munich: GRIN Verlag. Mankiw, G. N. and Taylor, M. P., 2006. Economics. Connecticut: Cengage Learning EMEA. OECD, 2003. Private Health Insurance in Australia: A Case Study. [pdf] Available at: < http://www.oecd.org/australia/22364106.pdf > [Accessed 17 September 2013]. Shamsullah, A., 2011. Australia’s private health insurance industry: structure, competition, regulation and role in a less than ‘ideal world’. [online] Available at: < http://www.publish.csiro.au/paper/AH10879.htm > [Accessed 17 September 2013]. Read More