The Perfectly Competitive Firm - Essay Example

Essay proper Outline the characteristics and behaviour of firms in perfect competition? The perfectly competitive firm The perfectly competitive firm is a firm that functions in a perfectly competitive market. In order for a market to become perfectly competitive, there are conditions that should be satisfied, which include: that the number of buyers and the sellers in the firm are so vast that each of them are so small to influence the price in the market; that these firms are selling a homogeneous product to the buyers, and that the extra revenue gained in every additional sale is equivalent to the market price. A perfectly competitive firm functions in a perfectly competitive market. A market is said to be perfectly competitive when the number of buyers are so enormous, that many small firms are required to participate in the market in order to meet these buyers’ demands. Because both the firms and the buyers are small enough to influence the price, both buyers and sellers can only take the market price of goods as to where to base their transactions. Any deviation from the market price will bring the firm back to the market price in a perfectly competitive situation. When a firm raises its price beyond the market price, selling a product the same as what the other players in the industry are selling, the buyer has no incentive to buy in that firm because he or she has many options from where to buy those products. This does not give any firm in a perfectly competitive market any advantage to increase the price they offer; therefore they accept the price in order to maximize their profits. Hence, these firms in a perfectly competitive market are called price-takers. Short-run shutdown point In a perfectly competitive market, variable costs are a vital part in determining the company’s survival. Because a firm competes in a market where the price cannot be determined by any single firm as it is small enough to influence it, when the market price goes down and puts firms into losses, the firm in the short-run still has an incentive to continue on its operations rather than to completely shutdown its business. Firm’s costs are classified according to variable costs and fixed costs—variable, in the sense that a cost’s behavior is consistent with sales, and fixed in the sense that any level of sales will not be able to affect it given a certain range. When a firm’s revenue still produces enough to cover the amount of fixed costs for a certain level of price, the fixed costs is still smaller than what costs the firm when it shuts down. When the market price falls below the firm’s ability to support its fixed costs, only then will it give the firm the incentive to shutdown its operations because shutdown will be less costly than the fixed costs. Therefore, when market price falls in the short-run the firm does not shutdown immediately. The firm will continue on its operations up to a shutdown point—where price does not generate enough coverage for the fixed costs. Only then will the firm has enough incentive to go out of business. 2. Why is the perfectly competitive model seen as useful for economists today? Perfectly competitive model and allocative efficiency While in real life, perfectly competitive markets seldom happen due to market failures, this model gives economists a picture of how an efficient market will be and be the basis for analysis of imperfect competitions. In perfectly competitive markets, what the buyers want are exactly met by the sellers at the price these buyers desire. This leads to full allocation of resources, when there is no wastage in the economy when the buyers get what they want for the price they want. From this analysis, the analysis of inefficiency due to price changes is derived. Models of imperfect competition therefore introduce the concepts of deadweight loss, for the inefficiency that their influence in price brings which symbolizes the wastage in the economy. When buyers demand a commodity for a certain price, because there are few players in the market which have influence over the output and price, not all the buyers’ demands are met. They may get a certain amount of output for a higher price, which leads to decrease in satisfaction. Because there are less firms that produce a certain commodity in order to meet the demand, not all the demands in the economy for that certain product is met—which therefore leads to wastage in the form of economic loss where the loss represent a portion of the resources which does not go to anyone in the economy. 3. When, if ever, may the existence of monopoly be justified? Pioneers in research and development for innovation Monopolies create a lot of wastage in the economy in the form of inefficiency because they are the only supplier of a product in a given market. Although this increase in inefficiency due to the monopolist’s control over price and output within the industry, the existence of monopolies has beneficial effects in the economy as well. With monopolies’ high level of profits which they derive by influencing the price and output within a given industry, these profits are sometimes channeled by these sole players in research and development. Monopolies, due to their high level of profits are the only entities which can afford to spend so much in the cost of research. Due to this, monopolies play a huge role in technological change within an economy as well as inducing innovation. By pioneering researches and being the only entities to afford large spending to influence technological change, the existence of monopolies is justified. Natural monopolies There are certain products that in real life, when it becomes subjected to market forces drastically hurt the consumers in some ways. These include utilities such as electricity and water where efficient production requires a single seller. Thus, monopoly in these types of commodities is even required by the government in order to provide protection to consumers. These natural monopolies serve to monopolize or take over a certain area where they provide the services. By monopolizing a certain area, the relative prices for utilities are stable over the course of time. If within a given area, these utilities are subject to the fluctuations due to increasing supply from a new entrant, or a decrease in supply when a new entrant leaves—the fluctuations can significantly hurt the consumers. Therefore, the existence of this kind of monopoly is justified. 4. Evaluate different ways in which the problems posed by monopoly may be reduced. Taxation Utilizing taxation has been one of the ways the government uses to reduce the effect of monopoly. By taxing the monopolist, the government drains the profits from the monopoly which aims to discourage it from increasing the price, and thus lower down its price in order to pay less in taxes. However, the increase in taxes does not have an effect on output; also, increase in taxes usually increases the monopolist’s costs of doing business. In some situations, this can give an incentive for a monopolist to further increase the price. Price controls Price controls come in the form of regulation which determines a certain ceiling or floor in the price of the commodity in such a way that the prices will not reach a substantially high amount to create so much inefficiency in the economy. While motives behind the putting of price controls are good for the part of the consumers, price controls usually creates more distortion and a rippling effect of inefficiency within the economy because of restriction of prices. This restriction of prices up to a certain level determines the interaction of the demand and supply within an economy, which determines a more efficient allocation of resources in return. Government ownership Government ownership is one of the ways in order to reduce the problems posed by monopoly. In cases where efficient production requires a single seller as in the case of utilities, government owns these monopolies in order to regulate them. This is the case for natural monopolies. Regulations: anti-trust laws In order to prevent monopolies from forming, the government creates industrial policies such as antitrust laws. These antitrust laws are formed in order to provide disincentives for companies to resort to monopolistic tendencies within their given industries. The antitrust laws prohibit any company from creating a cartel in order to get hold of the price and output within the industry. Encouragement of competition by lowering the barriers to entry Lowering barriers to entry encourages competition within an industry, both foreign and domestic. This sometimes comes in removing restrictive barriers such as policies which prohibits other players to enter the market, or providing incentives to players who will enter the market. Encouragement of competition within an industry induces other firms to produce the more products which will even out the supply in the market. This will have an effect on the price of the commodity, as well as the satisfaction of the consumers. Therefore, lowering the barriers to entry, if not sometimes completely removing them is crucial in addressing the effects of monopolies. 5. If demand for the product of an imperfectly competitive industry increases, what happens to the price of the product, the output of the industry and the profits of the firms within the industry? When the demand for the product of an imperfectly competitive industry increases, a shift in the demand curve upward illustrates it. When the demand curve shifts upward, a certain level of supply makes the output scarce and therefore pushes the price of the commodity upward. The increase in the demand for a certain product in an imperfectly competitive industry pushes the price of the commodity upward. This increase in price gives the players within the industry larger profits in return. For every price level, more output is demanded; in the same manner that for the previous level of output, higher price is demanded. Due to this price increase which also increases the profits of the players in that industry, the industry becomes more attractive. This gives incentive to new entrants to come to the market and help provide the increase in demand—which in the long run makes the industry more competitive in the process. In the long-run, the prices in the industry will tend to even out and return to previous lower levels before the increase in demand has taken place. 6. How may the existence of barriers to entry affect the outcome? When barriers to entry are present within an industry, the industry’s incumbent players will reap the rewards of the higher price due to the restriction of the output. Barriers to entry will prohibit new entrants from joining the market in order to provide for the increase in demand. This increase in demand, when met with a relatively stable amount of supply because the number of the players within the industry is not increased will only result in higher prices. The barriers to entry prohibit new supply from coming into the market in order to create distortion to the price and output. Therefore, when barriers to entry exist, the outcome would be different from that of the previous one. Bibliography Appleyard, Field, & Cobb (2006). International Economics 5th ed. McGraw-Hill Irwin. Nicholson, Walter (1997). Immediate Microeconomics 7th ed. Dryden. Varian, Hal (1999). Intermediate Microeconomics 5th ed. New York: Norton. Essay plan 1. A full outline of my plan. Essay proper 1. Outline the characteristics and behaviour of firms in perfect competition? The perfectly competitive firm A firm that functions in a perfectly competitive market Perfectly competitive market defined Considerations for perfectly competitive market to exist Large numbers of sellers and buyers which create a completely horizontal demand curve Each of them small enough to not affect the market price in any manner Perfectly competitive firm as market price-takers Short-run shutdown point Losses as effects of lower market prices for the firm’s average costs Distinction between fixed and variable costs Variable costs and the firm’s ability to cover fixed costs through sales Disincentive when firm chooses to shutdown and costs are higher than fixed costs Shutdown point: point where fixed costs will not be supported by sales and shutdown is the better alternative 2. Why is the perfectly competitive model seen as useful for economists today? Perfectly competitive model and allocative efficiency Benchmark for analysis of imperfect competition Inefficiency and deadweight loss as compated to efficient allocation in perfectly competitive model 3. When, if ever, may the existence of monopoly be justified? Pioneers in research and development for innovation Monopolists: the only entities who, with their profits could afford to spend huge amounts for research Natural monopolies 4. Evaluate different ways in which the problems posed by monopoly may be reduced. Taxation Price controls Government ownership Regulations: anti-trust laws Encouragement of competition by lowering the barriers to entry 5. If demand for the product of an imperfectly competitive industry increases, what happens to the price of the product, the output of the industry and the profits of the firms within the industry? Increase in the demand and the price of the product Increase in the demand and the output in the industry Increase in the demand and the profits of the firms within the industry Incentive for new entrants to enter the market Long-run effect in the output and price due to increase in players 6. How may the existence of barriers to entry affect the outcome? Barriers to entry to provide more control for the incumbent firms within the level of price and output within the market Number of players will still be limited and prices would not be so much affected Works Cited 2. Details of how my plan to research the subject matter. I start with consulting a major reference with regard to the subject matter. By reading a certain reference, I could gain enough knowledge to familiarize myself with the concepts, and therefore the starting point of my research. After learning the concepts, I start to find more resources about the subject matter which could provide clarifications regarding the points described in the main reference. Then with smaller bits of information, I can compose my arguments as foundations for my answers to the questions. Based on the understanding that I have developed as regards the subject matter, I am able to explain well the concept and answer the pertinent questions. 3. The structure of my answer. The structure of my answer follows my outline for each number. For every section, I provide an introductory statement before I expound my arguments. Then, I either summarize or conclude the points that I have raised per section which I use to divide my answer for each question. 4. A synopsis of my actual answer. Question 1 A perfectly competitive firm is a firm that functions in a perfectly competitive market. A perfectly competitive market has a large number of sellers and buyers, which, due to their large numbers they become small enough to not influence the price of the good in the market. When market price goes down, because any apparent attempt to increase in price will not give the firm any benefit in a perfectly competitive market, firms will incur some losses. However, getting out of business is more costly for the firm in the short-run. Thus, when its sales given the level of the market price can still over fixed costs, staying out of business is not yet the better resort. Question 2 Perfectly competitive model is seen to be useful by economists today because by looking at a model that displays how allocative efficiency works in a given market, efficiency of allocation can be further understood. The analysis of perfectly competitive markets provides a benchmark for the analysis of imperfect competition. Thus, the inefficiency of imperfect competition is gauged from the analysis provided by the perfectly competitive model. Question 3 The existence of monopoly is justified when monopolies serve as the driving force for technological breakthroughs and innovation through research and development. With large profits, monopolists are the only entities which can support very high levels of spending in R&D. These higher levels of spending result in better technology and innovation within the economy. Question 4 There are different ways in order to reduce the impact of monopoly. These include: taxation, price controls, government ownership, policies such as antitrust laws, and encouragement of competition. Each of these can be used to reduce the impact of monopoly; however, not all have equal effects on addressing the impact. Question 5 The increase in demand given a relatively stable level of supply will make the outputs scarcer. This results in a higher price within the market, which gives the firms higher profits in that industry. These higher profits attract new entrants in the market. As new entrants add supply to the market, the level of output becomes less scarce, thus bringing down the price. The incumbent players of the industry have therefore not enjoyed the profits for a longer period of time due to the coming of new entrants. Question 6 Barriers to entry provide the incumbent players a certain level of control over price as they have control over the level of output that is produced. When the level of the demand increases, price also increases given a relatively stable supply due to a limited number of players. This gives the industry players higher profits. Even when profits are high enough to be attractive, when there are barriers to entry, new entrants would find a harder time to get into the market and affect the level of supply. Thus, the incumbent players enjoy a relative increase in profits due to higher demands, with the existence of barriers to entry. Bibliography Appleyard, Field, & Cobb (2006). International Economics 5th ed. McGraw-Hill Irwin. Nicholson, Walter (1997). Immediate Microeconomics 7th ed. Dryden. Varian, Hal (1999). Intermediate Microeconomics 5th ed. New York: Norton. Read More