Economics – Perfect Competition
Mixed Economy This is the practical application of both Market and Command economies, where the production of commodities by private organizations are monitored by the Government. This type of economy, in theory, should achieve the balance between the two extremes of Market and Command economies. Closed Economy Also known as Import Substitution Industrialization (IS’), this economy is closed from foreign nations. Usually adopted by developing nations, the main focus of an SIS Closed economy is to reduce the dependency on developed countries and become elf-sufficient by encouraging domestic production (www. Investigated. Com). Open Economy This type of economy has the opposite features to that of a Closed economy, where the country is open to foreign exchange and foreign trade. Also known as Export Oriented Industrialization, it aims to boost economic growth through the exchange of commodities between countries. 2. Market Mechanism As mentioned above, a Free Market Economy is one type of economic structure which had developed to solve the problem of Scarcity. The market mechanism functions according to the forces of Demand and Supply.
Gain and Sand, (2008) discuss, the here basic questions of economics are solved in a market mechanism as follows: What to produce is determined by the
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The producers will supply what is demanded by the consumers, to those who are willing and able to purchase it. Consumer Sovereignty – In the market mechanism, what is produced is determined by the consumers. In this case there is consumer Sovereignty. This means that ultimately it is the consumers who have the power in a market system. Private Business – All Land and Capital are privately owned in this system, and it is private individuals or firms that produce the commodities that are demanded by the consumers. No Government Intervention – In this system there is no government influence or intervention on the Market Forces.
The main role of a government in this system is limited to the provision of public goods and services, imposition of Taxes and maintenance of the legal system. The government is only able to oversee the market forces at play, and cannot intervene or influence. 2. 2 Price Mechanism The price mechanism, also known as the Invisible Hand, was introduced by Adam Smith in 1778 (Smith, 1982), and is, theoretically, the core of the Market Mechanism. The price mechanism is the “Invisible” force by which the Demand and Supply in a free market determines the optimal or Equilibrium Price which is beneficial to both he producers and consumers. Age | 7 Figure 1: Demand and Supply The above illustration depicts a basic linear demand and supply diagram. A high price is preferred by the producers of a commodity, but not the consumers whose demand increases as price falls. Therefore the price mechanism determines the price, and the market will come to an equilibrium price where both the producer and the consumer will benefit. 3. Perfect Competition A theoretical example of an efficiently functioning Market Mechanism is seen though the concept of a Perfectly Competitive market. This concept was introduced by Adam
Smith in 1778 (Smith, 1982) in an attempt to illustrate that a market mechanism can function efficiently, given certain criteria and assumption. 3. 1 Features of a Perfectly Competitive Market The features of a perfectly competitive market are as follows: Many buyers and sellers – In a perfectly competitive market there are many consumers and producers of a product. As a result no single producer has a high degree of power or influence in the market, and each producer only produces a small fraction of the entire market supply. Similarly no single consumer has a high degree of control or influence in the market Cain and Sand, 2008).
Page | 8 Price Taker – As a result of the large number of producers in the market, each firm is a price taker, and not a price maker. This means that the firms must accept the equilibrium price set by the market forces, and no single firm can influence the price by increasing or decreasing the quantity supplied (Divvied 2006). Homogeneous Products – In this market system, all firms produce the same or similar product (homogeneous). There is no differentiation between products of various suppliers, therefore if one supplier raises his price even by the smallest margin the consumers will immediately switch to another producer of the product.
Free entry and exit – There are no rules or barriers restricting entry into or exit from the market. This means that firms are free to Join or leave as and when they desire. The Demand curve for a perfectly competitive firm is perfectly elastic (horizontal). This reflects the concept of “price taking” where the firm must sell at the price determined by the market forces (Hall and Lieberman, 2012). (Source: Author’s Work) Page | 9 The above diagram shows the price as determined through the forces of demand and supply in a perfect market. The equilibrium price is determined at the point here the market demand meets the market supply.
This price then becomes fixed for the individual firm. As a result, the firms price is the same as its Marginal Revenue and Average Revenue (D=MR.=AR=P). The individual firm will then function on this perfectly elastic demand curve. Like any private firm, a producer in a perfectly competitive market seeks to maximize profit. Due to the inherent features of a perfect market such as price taking and free entry and exit, firms can only earn a profit in the Short Run. Figure 3: Short Run Profit The profit maximizing firm will set the optimal output level (Q) at the point where MAC=MR..
In the short run a firm can either earn excess profit (as seen in diagram A) or zero profit (as seen in diagram B). In the above illustration, diagram A shows a firm whose revenue (D=AR=MR.=P) is higher than the Average Total Cost of production (TACT). As a result this firm will earn an excess profit in the short run (SORTS). Diagram B shows a firm earning Zero profit, where the revenue equals the cost if production of the firm. Either way, a firm will continue to produce in the short run as long as the revenue earned is greater than the short run average variable cost of production (Weasels, 2012). Age | 10 Figure 4: Long Run Loss As per Bamboo and Blinder (2008), the short run profit will attract more producers into the industry in the long run, and this increase in the market supply will reduce the market price (D=AR=MR.=P). This will result in the firm incurring a loss in the long run, depicted by LIMPING (Hall and Lieberman, 2012). These loss making firms will leave the industry, leaving room for new entrants, thus driving the price up again. 3. 2 Assumptions The theoretical concept of a perfectly competitive market functions based on several key assumptions.
These are as follows: Perfect knowledge and information – A main assumption of a perfectly competitive arrest is the perfect availability of and access to information. In this type of market, it is assumed that all the consumers have all the information regarding the Availability of Infrastructure – This market also assumes that there is perfect infrastructure, systems and structures in place to facilitate the smooth functioning of the market. Page | 11 No Transaction or Transport costs – Another main assumption is that there are no transport costs and transaction costs in the market.
The only cost to the producer and consumer is the cost of production and price of the product respectively (Goodwin et al, 2008). Consumers are rational – The consumers in this market are assumed to be rational individuals who take rational decisions based on the information available. Factor Mobility – This market also assumes that there is perfect mobility between factors of production (land, labor, capital and enterprise), where the factors can be switched with changes in market conditions (www. Tutor. Net) 3. Benefits of a Perfectly Competitive Market In theory, a perfectly competitive market can result in Economic Efficiency, since the questions of What, How and For Whom are answered by the market forces of Demand and Supply and the Price Mechanism. This means that the perfect market will achieve: Productive Efficiency: Where firms are encouraged to produce at the lowest total cost (lowest point of the TACT curve). This results in increased efficiency in production of each individual firm, and thus the industry as a whole (Sexton 2012).
Allocation Efficiency – The market functions effectively and efficiently in allocating scarce resources. This means that the resources are allocated based on the needs and wants of the consumers, hence there is no wastage of resources (Sexton 2012). An efficiently functioning Perfectly Competitive Market can benefit both the reducers and the consumers as follows: 3. 3. 1 The Producer Lower Costs – The perfectly competitive market assumes that firms do not incur any transportation or selling costs, and this enables the producers to keep costs to a minimum.
Higher Profits – Due to competition, the producer is encouraged to increase efficiency and reduce costs of production in order to maintain the TACT below the market set price. Page | 12 This as mentioned above leads to Productive and Allocation efficiency, as there is minimum wastage, and allows the producers to earn high profits in the Short run. 3. 3. The Consumer Lower Prices – Consumers will benefit from lower prices as firms compete to keep cost of production low. As individual producers have no power, the price cannot be influenced or inflated to earn higher profits.
High Quality Products – Also due to the homogeneity of products, the only way firms can attract customers is through better quality products than its competitors, and this in turn will benefit the consumer. 4. Market Imperfections The Perfectly Competitive Model is only a theoretical concept of how a market could function, based on several assumptions as stated above. However these assumptions are unrealistic and such perfect markets cannot be found in the real world. This is due to imperfections in the market.
For instance when considering the homogeneity of products, no two firms have the same product, as every firm differentiates and brands its product in some way. Many firms in both developed and developing countries depend on product innovation which is not allowed by the rules of a perfect market. Also the assumption that a perfect market has no transportation or selling costs cannot be seen in the market for an actual product, as all suppliers must incur some mind of advertising and logistical expense. Not all Markets have many buyers and sellers.
A Monopoly market (one supplier in the market) for a product may exist for goods such as Electricity. This also restricts the freedom of entry into the market and exit from the market. A monopoly producer can also influence the price of the product, making it a Price Maker (Price Setter). 4. 1 Developed Countries Markets in Developed countries possess some of the assumptions required for a perfect market to function such as proper infrastructure and communication networks than those in developing countries.
Developed countries also have skilled labor in most markets, unlike developing countries, and these countries have the financial resources to train the labor force. Developed countries also have a high technological capacity, and these sophisticated technical processes allow high efficiency and low costs of production. However even among developed countries there may not be perfect market as some of decomposition cannot be found. For instance, Factor Mobility may be present in the European Union to some extent, where labor, capital and enterprise can be moved between countries but this not present in all developed countries.
There may not be perfect information, as there is no way for all the consumers and producers to have all the information pertaining to a market. The assumption that there are no transaction and transport costs is also highly unrealistic, as all producers in both developed and developing countries incur some kind of selling and distribution cost. 4. Developing Countries Market Imperfections are more prevalent in developing countries whose low living conditions cannot facilitate the requirements of a perfect market. There is little infrastructure development and a lack of communication and transport networks.
This in turn increases the costs of transportation, which again goes against the assumptions of a Perfect market. Developing countries have little or no factor mobility. Also developing countries have a higher level of corruption and bureaucracy and this influences the markets for certain products. These countries also have a low level of skilled labor, and not enough financial resources to provide training to the workers. Developing countries also have low technology level as well as low capital to invest in such technology, and this results in primitive production processes and low technical skills.
Wad (1980) explained that a perfectly competitive market, despite its benefits to both the producer and the consumer, has several weaknesses: No Innovation – Due to product homogeneity and fixed prices producers have no incentive to innovate, and thus firms cannot gain a competitive advantage in the industry. This also leads to a lack of variety and choice for the consumer, which is one of the Lack of Product Choice – A main reason for the encouragement of competition in a market is the advantage of choice for the consumer. In a perfectly competitive market there is product homogeneity and therefore no consumer choice and variety. Page | 14