How Perfect Competition Leads to Allocative Productive and Dynamic Efficiency - Assignment Example

Question 1 Explain with the use of diagrams where appropriate how perfect competition leads to allocative productive and dynamic efficiency Perfect competition This is a market structure that is assumed too strong and cannot exist in the real world market situations. The market is characterized by the following main features (Besanko & Braeutigam, 2010); Presence of many buyers and many sellers Ease of entry and exit into the market as the costs are minimal Homogeneity of the products on sale and as such the products are perfect substitutes making seller be price takers Perfect knowledge of the market by both sellers and buyers Factors of production are mobile With these assumptions, perfect competition can be viewed as a market structure that can be used to achieve efficiency in the market through in the following ways. The figure below shows a point where P=MC where allocative efficiency is achieved. Allocative efficiency This is achieved both in the short run and long run period where the price is equal to marginal cost (P=MC). This ensures that allocative efficiency is achieved since both the consumers’ and the producers’ surplus is maximized at the point where marginal cost equals the price. This is achieved because the individual firm is a price taker in a large market and thus cannot influence price. In a flat demand curve the firm will have one price. The firm will therefore produce until it has achieved volumes that will cover marginal costs at the point where the marginal cost is equal to marginal revenue. This means the consumer and the producer each benefit from efficient allocation of resources or what can be referred to as Pareto optimum allocation of resources, where the firm produces the right amount, to the right people, at the right time and at the right price for both players in the market (Fried, Lovell, & Schmidt, 2008). Dynamic efficiency is also achieved purely because the firms in perfect competition deal with homogeneous products that are perfect substitutes. It is assumed that the homogeneity of the products ensures that there is little room for innovation and thus no players can innovate to differentiate the products and create a monopoly in the market (Fried, Lovell, & Schmidt, 2008). Question 2 (A) Illustrate with the use of diagrams how the profit maximising price and outpur for firms in a monopolistic competitive market structure is determined Monopolistic competition Monopolistic competition is a common or imperfect market structure that can be found in real world markets. There are many buyers and sellers in the market but the products are differentiated. The market is almost similar to perfect competition but firms have a degree of price determination in the market due to differentiated products (Solow, 1998). Price maximization under monopolistic competition is achieved when MR=MC. in the short run the price=AR is higher than ATC meaning there are supernormal profits but when new entrants begin coming in the price; is revised downwards as demand curve shifts leftwards. The profits erode and we have a new price where P=ATC and MC=MR and a new quantity As illustrated below. Does the fact that monopolistically competitive markets do not achieve allocative or productive efficiency mean that there is a significant loss in economic well-being to society in these markets? The fact that the market does not achieve allocative or productive efficiency means that there is economic loss suffered by the society sine the firms do not fully exploit the production factors since mass production is not possible. The firm also incurs extra costs in differentiation but may deliver value in terms of differentiation and choices to consumers. Question 3 What is a natural monopoly? If a firm is a natural monopoly, illustrate with the use of diagrams why is it is necessary to have the price set by a regulatory authority rather than by the market Natural monopoly This is a special kind of monopoly where efficiency can only be achieved by concentrating production into a single firm in the market. This kind of market structure exists where prohibitive high costs of production are involved. As such economies of scale can only be realized through high output. In fact in most cases the producer has to meet the total market demand single handedly at a high cost (McKenzie, 2008). Most common forms of natural monopolies are in essential services industries such as electricity distribution and water distribution where the initial capital outlay is massive and thus a new entrant with limited resources will struggle to achieve economic efficiency in terms of large scale production to lower the price. The firms may in the long run tend to abuse the natural monopoly power in the industry since there are no other players. This necessitates the need to have the price regulated by authorities rather than by the market where the firm is a price giver and not a price taker. In relation to the figure below, if a firm is privately owned, it may decide to set the price at the point where the quantity is to achieve efficiency and supernormal profits much to the suffering of the consumers due to the high price (McKenzie, 2008). Question 4: Explain with the use of examples the concept of positive and negative externalities Illustrate with the use of diagrams how government intervention can correct them Negative externalities This is basically an unnecessary cost suffered by a third party from an economic transaction. They may arise from consumption where the effect may include waste or production where the effect may include harmful emission. The producer and the consumer air the first and the second parties respectively in a transaction while the third party is a person or organization affected indirectly by the transaction (McKenzie, 2008). Negative externalities mostly occur where property rights are not clear or have not been allocated at all as such actions that may have negative effect may be committed with no fear of being charged an example will be the harmful effects of alcoholism of the societal development. While the alcohol does not directly affect economic production when working population becomes unproductive, it does so indirectly. The economy is a third party affected by consumption of alcohol. The government may intervene by taxing alcohol consumption to reduce the production from free market allocation to socially efficient allocation. This pushes the price up and reduces consumption of alcohol thus reducing the magnitude of negative externality. The figure below shows the effect of taxing alcohol production where the welfare loss is reduced to nil after taxation of negative externality in the market (McKenzie, 2008). Positive externality This is a benefit enjoyed by a third party as a result of an economic transaction in which the third party was not directly involved. It is also as a result of production or consumption activities which result in positive impact on societal welfare. In most cases positive externalities are under-consumed or under-produced by the private sector due to pricing and valuing of the goods or services that trigger positive externalities. The government may increase supply for goods and services that generate positive externalities such as schools or healthcare facilities by subsidizing production of goods and services. The government may also increase demand by subsidizing consumption of the goods and services such as reduction of tuition fees or medical fees (McKenzie, 2008). As can be seen in the figure below, social benefit of consumption is greater than private benefit with positive externality. There is a therefore a case for the government to encourage consumption. Question 5: (a) Outline a micro-economic reform issue that is relevant to the Australian economy i.e. why has there been reform in this industry or market? Microeconomic reforms in Australia Major economic reforms occurred in Australia in the 1980s to spur economic growth and to make the economy competitive by increasing efficiency rather than protecting inefficiencies in the economy through tariff restrictions advised by a desire by the previous economic regimes to protect the economy from external competition. The government hoped to spur economic growth through the reforms. The general idea was to reduce regulation in the market to allow for firms to become efficient in their production and thus become competitive globally. In essence then the emphasis was on opening up the market to make it competitive where forces of the market dictate the prices. The resulting situation would be firms achieving productive and allocative efficiency and thus giving value to consumers through efficient exploitation of production resources (Mckenzie Maragaret, 2006). The resultant benefits to the economy as anticipated by the productivity commission of Australia then would be improved living standards through improved economic efficiency. The government intentions were to enhance flexibility in the economy so that investment, employment and other production resources could be utilized in more productive activities that will add value to the economy instead of surplus production in the economy that does not fit with the demand in the economy and thus slowing down economic growth. Also included in the reforms were efforts directed towards improving technical efficiency through upgrade of technology and management practices (Mckenzie Maragaret, 2006). The reforms were necessary in helping the economy achieve productive and allocative efficiency that would make it competitive. It also solved another major problem in the economy in the form of lack of specialization and economies of scale that made the firms less competitive as compared to other sectors in advanced economies. In essence then the reforms were to make the economy more flexible and adaptable to competition (Mckenzie Maragaret, 2006). (B) How successful do you think these reform measures were and say why referring to some data or research that has been performed? The reforms achieved multifactor productivity (capital and labour productivity) in the Australian economy in the 1990s. Multifactor productivity (MFP) grew at an average of 2.4% every year from 1993 to 1998 as compared to 1.2% from 1965 to 1992 (Mckenzie Maragaret, 2006). This was greatly attributed to increased productivity arising from better allocation of resources in production, enhanced specialization in the economy and better management and work practices. Mackenzie (2006)notes that it is also important to note that employment shifted from traditional industries of producing utilities to service production. Capital investment also shifted towards productive assets in the technology sector. This impressive trend which was termed as a break from the past by the productivity commission would not have happened without the key economic reforms specifically targeting to increase productivity and allocative efficiency in thee economy. References Besanko, D., & Braeutigam, R. (2010). Microeconomis (4 ed.). John Wiley and Sons. Fried, H., Lovell, K., & Schmidt, S. (2008). The Measurement of Productive Efficiency and Productivity Growth. Oxford University Press. Mckenzie, M. (2006). Microeconomic reform and productivity in Australia – boom or blip. Working Paper- Deakin University Australia . McKenzie, R. (2008). In Defense of Monopoly: How Market Power Fosters Creative Production. University of Michigan Press. Solow, R. M. (1998). Monopolistic Competition and Macroeconomic Theory. Cambridge University Press. Wessels, W. (2006). Economics. Barron's Educational Series. Read More