Perfect Competition and Monopoly - Essay Example

? (a) Explain why perfectly competitive firms cannot make supernormal profits in the long run butmonopolies can. Perfect Competition & Monopoly The producers make and sell their products in the markets, places where buyers and sellers meet, to achieve the highest possible profit they can get. So the goal of the firm is profit maximisation. We shall study the two types of markets – perfect competition and monopoly, and discuss why in the long run the former earns normal profit but the later earns more than that. Perfect competition is a type of market which fulfils all these five assumptions. 1. The size of the firm relative to the market is small. Hence, it has no influence on price. The firm is a price taker. 2. The product is homogeneous meaning to the consumer the product of one seller is same as the product of other seller. 3. There is freedom of entry and exit for each firm. 4. There is free mobility of resources. 5. All the participants in the market have perfect knowledge, meaning that everyone is aware of his benefit, consumer knows prices, and producer knows cost and so on. If even one condition is not fulfilled, the market will not be perfect anymore, it will be imperfect. An extreme case of such imperfection is monopoly. Monopoly is that market in which there is only one seller (or a group of sellers acts as one - cartel) of a commodity that has no close substitute. The seller has complete control of the supply of the commodity and hence is the price maker. We shall now see where the equilibrium of the firm lies and also which conditions are necessary for it. Equilibrium of the firm We shall use the marginal revenue1 and marginal cost2 approach to study the equilibrium of the firm. There are two conditions to this equilibrium: 1. MR = MC 2. Slope of MR < Slope of MC. Price MC P T P MR=AR=P Quantity (output) 0 Z? Z As we can see in the above graph, there are two points where marginal revenue is equal to MC but at Z? if the quantity is increased, the firm is still earning profit. But after Z, the cost of per unit is more than its price. Hence Z is the equilibrium output. The equilibrium can be proved mathematically. Let Z be the output, TR the revenue and TC the cost. Profits are calculated as ? = TR – TC. To maximise the profits we need i.e. MR = MC, and i.e. Slope of MR < Slope of MC. Equilibrium in Perfect Competition and Monopoly in the Long Run As we are trying to see how both markets generate different profits in the long run, we shall assume that the market demand and costs do not change due to entry and exit of a firm from the industry. Also, to simplify the analysis constant average cost is assumed. These assumptions give us MC = AC and the supply curve for perfect competition is equal to both costs. The equilibrium in perfect competition will be at the point where demand is equal to supply as this is where the price3 will set. The output will be according to this level. At this level price will be equal to MC and AC. In general, we can state the equilibrium in perfect competition as P = AR = MR = MC = AC Where P = Price of the commodity AR = Average Revenue MR = Marginal Revenue MC = Marginal Cost AC = Average Cost4. In case of monopoly the equilibrium will take place where marginal revenue is equal to marginal cost and the marginal cost curve cuts marginal revenue from below but there is an additional clause here that states that the marginal revenue will be less than the price. We can see both the equilibriums – for perfect competition and monopoly, in the figure. Comparison of Profit between Perfect Competition & Monopoly The comparison can be seen in the figure above. In perfect competition the price is fixed. Only the output varies and therefore supply curve is horizontal. The equilibrium price for competitive firm is Pc, where MR=MC. But the output level is Qc where MC= AR, meaning supply is equal to demand. For monopoly, the equilibrium position is same, where MR=MC, but the output level is fixed at Qm. The price level is decided at Pm. So it can be seen that in monopoly a smaller quantity is fetching a higher price, whereas in perfect competition its vice versa. Monopolist is earning more at less output than a firm in competitive market is earning on larger output. His cost per unit is Pc but he is charging Pm. the difference in these, Pm – Pc, is called monopolist’s mark-up. In perfect competition, at equilibrium, all firms earn normal profit in the long run whereas in monopoly, the firm is always earning super normal profit. This is due to the mark-up which a monopolist can charge, as he is the single distributer of the commodity and consumer has to buy it from him. So he can earn supernormal profits in the short as well as in the long period. The firm need not equate the AR to the lowest point of AC in the long run. But in the perfect competition, the consumer has perfect knowledge and perfect substitutes available to him. Hence a perfect market firm has no hold on him. In the short run, the firm might earn supernormal profit5 but in the long run, perfectly competitive firms can only earn normal profits. References Maddala G.s and Miller E (1989), “Microeconomics: Theory and Applications”, McGraw-Hill Companies. (b) Discuss the advantages and disadvantages of free trade. Why do some countries use trade barriers if the advantages of trade are so great? Free Trade and Trade Barriers Trade is one of the oldest businesses of the world. People used to trade commodities which they did not have with those that they needed without any restriction. Than governments started watching their economy and made artificial obstacles to control the flow of trade. The world today is becoming a global village. But even at this age of advancement, trade is not completely mobile. Tariffs, quotas and other forms of artificial trade restrictions are used to limit the mobility of goods and services. There is a school of thought that advocates these restrictions but there is another that wants no barriers on the movement of goods and services and labour. This group supports free trade. Free trade has no artificial barriers or restrictions on import and export of goods and services and it also promotes mobility of labour. There are many a debates going on whether the trade restrictions are good for the economy or does it make a country lose its own industry. These debates have been going on for over a century. There are countries that have created free trade areas. These are areas in which the intra-trade has no barriers but areas or countries outside these zones face restrictions. As it is an on-going debate, we shall study both – the pros and the cons. First we will discuss the biggest advantage of free trade, increased productivity and efficiency. Adam Smith (1776) stated in his book “Wealth of nations” that if a country which produces a commodity comparatively cheap, than any other country, to which the commodity is dear and expensive, should buy it off and produce its own in such a way that it is advantageous to its economy. The principle of comparative advantage, given by Ricardo, is based on the relative efficiencies of production where each country has a comparative advantage in producing the commodity in which it has the lower opportunity cost. Hence they will not produce goods in which they face higher cost of production and rather import it from a country which produces the commodity at a cheaper rate. The resources they will save can be expended on the products that can be produced cheaply in their own country, meaning products with lower opportunity cost. Hence they will achieve efficiency in productivity by producing and then specialising in a product cheaper to them. With specialisation countries are able to take advantage of efficiencies generated from economies of scale and increased output. These surpluses can be traded with other countries for their surpluses. Hence there is an overall gain in welfare and the increased competition, due to openness of the economy, will result in better allocation of resources resulting in higher productivity and increasing total domestic output of goods and services. Second advantage of free trade is that the consumer will get a larger variety of products to choose from and if there is a cheaper product available in the market, the consumer can pay less for buying the same commodity. Also, to gain customer attention, companies want to stay in the game and hence they try to get a comparative advantage by innovation of their products and paying attention to research and development of their products. Increased market size would result in competition, which in turn promotes advanced production methods, the use of new and innovative technology, product marketing and its distribution procedures. The increase in overall welfare can be measured through the size of consumer and producer’s surplus. Consumer surplus is the different between the amount that consumers would be prepared to pay for a good or service rather than go without, and the price that they actually pay for it. On the other hand producer surplus is the difference between the price that producers would be prepared to sell their produce at and the price that they actually sell it at. Price Supply X P2 A B SW+tariff P1 C D E F SWorld Demand O Q1 Q2 Q3 Q4 Quantity The above graph shows the domestic market before and after free trade. The tariff is lifted in free trade and it leads to a decrease in prices and hence an increase in consumer surplus. This increase in surplus is of area P2BEP1. The imports increase from Q3-Q2 to Q4-Q1. The government loses its import tax (area ABED). Domestic producers will lose the producer surplus (area P1P2CA). But on the whole the economy’s welfare has increased by area ADC and BEF. The increase or decrease is dependent on the elasticity of demand and supply. If the commodity has high elasticity of demand, higher the welfare quotient in the free trade. We have discussed the advantages of free trade. Now we see what the disadvantages are. First even if there is an increase in the consumer satisfaction due to increased trade, the local producers will suffer from it, especially the infant industries. These industries are new and will struggle to survive if international trade opened up completely. But given time and investment these industries might grow and get there bearing in order, even enough to get comparative advantage of their own. This time is given to them by using trade restrictions in the form of tariff or quotas, etc. If only comparative advantage is taken under consideration than the agricultural based economies, almost all are developing countries, will only work at producing agro-products. This will cause them many problems. First, there products base will not be diverse. Secondly, these products are generally inelastic in their nature; their demand is not that flexible, this means there growth is not too strong. Also the prices can fluctuate a lot due to many reason; whether they be political, social or environmental. If trade is free than a number of industries will close down due to no work and hence structural unemployment may take place for a short term. The families of those unemployed will suffer and it falls on the government to assist them. Another thing that can occur is the increased economic instability due to the increased uncertainty in the international market. The international trade cycles can have a marked impact on the country’s economy especially when trading partners are going through them. The domestic economy becomes dependent on global markets. Dumping is a very adverse effect of free trade. It harms the local industry especially in case of developing countries. Agro-economic countries face unfavourable terms of trade, as their export income is very small as compared to their import payments, to pay which they run up foreign debts. Government can increase its tax earnings by levying tariff on imports and protectionism might help the balance of payments in the short run but in the long run other countries might do the same. After studying both the advantages and disadvantages of free trade, it can easily be seen that even with good intentions, the free trade gainers are mostly big and already established economies and they face favourable economies of scale due to free trade whereas for emerging industries in budding economies of developing nations requires some more time to get their feet steady on the ground. That’s why it is important to protect them and give them time and space to establish their comparative advantage. References Benefits of free trade n.d. Retrieved August 16, 2010, from http://www.economicshelp.org/trade/benefits_free_trade.html Egde k 1999, Free trade and protection: advantages and disadvantages of free trade, Retrieved August 16, 2010 from http://hsc.csu.edu.au/economics/global_economy/tut7/Tutorial7.html Read More