Introduction to Unit 4
Definitions of key terms:
- Normal profit: the minimum reward required to keep a firm in its current line of production.
- Price maker: when firms have the power to decide the amount charged.
- Long run: the timescale in which economies of scale may work and over which all factors of production are variable.
- Allocative efficiency: the traditional objective of firms where MC = MR; profit maximisation.
- The demand curve: a graphical representation of the concept of how the number of consumers willing and able to purchase a good or service decreases as price increases.
- Homogeneous: goods and services that are identical in a given market.
- Short run: a period of time in which at least one factor of production is fixed.
- Variable cost: total required monetary payments for production less those which remain constant irrespective of output.
- Economies of scale: benefits from being big, for example bulk buying.
- Abnormal/supernormal profits: profits over and above the level of regard necessary to keep a firm in its present occupation.
- Price taker: where firms have no power over the price they charge.
- Marginal cost: required monetary payment for producing an extra unit of output.
- Barriers to entry: obstacles faced in entering a market.
- Product differentiation: major difference between perfect and monopolistic competition.
The Internet and perfect competition
Buying on the Internet is best suited to replacement purchases, where an individual or business buys a good or service identical to one they have already purchased, for example a holiday. The purchasing of goods and services is easier on the Internet as the online firm is more able to compete with high street retailers for replacement purchases. For new purchases high street retailers are more attractive as they offer the option to try garments on and for the consumer to select the exact item they want.
Services such as banking and insurance or buying pre-packed items on a weekly shop such as canned food is successful over the Internet as the consumer knows all cans of food are identical and the services offered by banks online are the same as those on the high street, offering offer a better service through more competitive interest rates, for example. The purchasing of fruit and vegetables is not appropriate online however as consumers want to feel the produce before they buy it and not rely on another's judgment.
To what extent do the markets for CDs and books demonstrate the characteristics of perfect competition?
There are a large number of firms offering homogeneous products and the Internet gives consumers near perfect information as Internet search engines allow price comparisons very quickly. However, not all these firms are small (some, like Amazon are very large) with some dominating areas of the market. The barriers to entry are reasonably low as to setup a website to sell books with low stock levels is not a very risky venture though it is debatable if firms could be described as price takers as whilst consumers can see lower prices in some stores they may choose to buy elsewhere with somewhere they trust more, a form of non-price competition so the market does not resemble perfect competition perfectly but has strong characteristics of perfect competition.
Explain the effect the Internet is likely to have on prices
Consumers are able to find the cheapest supplier online and so consumers will buy from the firm charging the lowest price. This means higher price suppliers will have to lower their prices or see a dramatic reduction in sales. This causes prices to converge and profits to decrease from supernormal to normal as firms aim to undercut their competitors.
What are the potential longer-term effects of the general trend in prices?
Firms in perfect competition are all assumed to have the same cost structure, as shown in the diagram. The equilibrium market price for the good or service is P1. A firm cannot charge a higher price than this as in perfect competition there is perfect knowledge so they would sell nothing. A firm chooses not to charge a lower price as they desire to maximise profits. Given this price the firms demand curve is perfectly elastic. For the firm all outputs where the AC curve is lower than the AR curve there is a profit to be made. O1 is the output for the firm at which profit is maximised as this is the point where the MC curve crosses the AR curve. When the MC curve is lower than the AR curve increasing output will lead to an increase in profits as it cheaper than the market price to produce the extra unit of output, so a profit can be made. For an output level above O1 the cost of producing an extra unit of output is higher than the market price and so producing this unit of output would add a negative value to profits, so decrease them. At the level of output O1 the firm makes abnormal/supernormal profit of magnitude P1ABC.
Homework: In perfect competition what would happen in the long run in this industry?
Abnormal/supernormal profits in the market act as a signal and new firms enter the market. This causes the supply curve to shift outwards from S1 to S2 as more firms are willing and able to supply at a lower price. This is shown on the diagram below.
This decrease in the market price means firms must lower their prices as in perfect competition all firms offer homogeneous products and there is perfect knowledge so if the firm does not lower its prices it will not sell any units. Firms aiming for profit maximisation will produce the output at the point where the MC curve crosses the MR curve for the reasons explained above. As the new MR curve, MR2 is lower than MR1. This causes output by the individual firm to decrease from O1 to O2 but equilibrium quantity supplied in the market to increase form Q1 to Q2. This decreases the supernormal/abnormal profits of firms from P1ABC to P2DBC, though the proportional size of these changes will depend upon the shape of the firms cost curves and the price elasticities of supply and demand within the market for a particular good or service.
In the long run as more firms enter the market the supply curve will continue to shift outwards and eventually reach S3 as shown on the diagram below. For each firm profits are decreased to a normal level and productive efficiency occurs as production occurs at the lowest point on the AC curve, goods within the market are produced as cheaply as possible.
The model of perfect competition makes many assumptions. One of these is that all firms have the same cost curves, which is unrealistic. In a real situation some firms are more efficient than others and the less efficient firms will have higher AC curves than the more efficient firms. This means that when the price level drops below a given level some firms will not make normal profits in the short and long run. These firms will leave the industry, thus leading to further efficiency gains.
These notes are from lessons on 22/06/2004 and 23/06/2004, and homework set on 23/06/2004.
