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JANUARY 2016
SpotNomics
MONTHLY NEWSLETTER
Department of Economics
Content Editor: Dr. E. Azzopardi
Contributor: Mr. C. Fava
This Issue
Great Economic Thinkers
Summary of Perfect Competition
Q & A—Perfect Competition
Great
Economic
Thinkers
Ernst Friedrich Schumacher
Pope Francis in his address
during the Third World Forum of Local
Economic Development argues that the simplest and most appropriate measure and indicator for implementing the new Agenda
for development would be the effective,
practical and immediate access of everyone
to indispensable material and spiritual
goods………the only way to achieve these
objectives truly and in a permanent way, is
by beginning to work at the local level. In
my meetings with popular movements and
with Italian cooperatives I recalled and developed these ideas, which can be summarized in two axioms: “small is beautiful”,
and “small is effective”.
Perfect Competition
In a perfectly competitive market it is assumed that there
are a large number of small firms that produce a homogeneous product. Firms are price-takers. There are no barriers to entry or exit and there is perfect knowledge of the
market.
The firm’s equilibrium output is that at which marginal
revenue (and average revenue) equals marginal cost.
In the short run, the perfectly competitive firm (as in any
other type of market structure) may stay in production
providing it can cover its variable costs. Hence, the perfectly competitive firm’s short-run supply curve is its marginal cost curve above its average variable cost curve.
If firms in the short run are making abnormal profits, then,
in the long-run new firms will enter the industry, increasing market supply and thus reducing price. This will continue until only normal profits are being made. If production is unprofitable, firms will leave the industry, reducing
market supply and increasing price. This will continue
until only normal profits are being made.
Long-run equilibrium requires that price equal the lowest
value of long run average cost. In other words, firms must
be producing at the minimum point on their long run average cost curves, because to maximize their profits they
must operate where price equals long-run average cost
(productive efficiency). Long-run equilibrium is also
characterized by firms producing where price equals long
run marginal cost (allocative efficiency). Put differently,
the cost of producing the last unit (MC) equals the satisfaction derived from that unit (P). It would be impossible
to reallocate resources in such a way as to increase economic welfare.
Ernst Friedrich Schumacher and his famous
work “Small is Beautiful” were specifically
mentioned by Pope Francis during such important Forum. The phrase "Small Is Beautiful" is often used to champion small, appropriate
technologies that are believed to empower people
more, in contrast with phrases such as "bigger is
better". He blasts notions that "growth is good",
and that "bigger is better", and questions the appropriateness of using mass production in developing countries, promoting instead "production
by the masses".
Source: L’Osservatore Romano, Friday 23 October 2015, page 12
“I and the Village” by Marc Chagall (1911)
Perfect Competition—Q & A
Markets close to the perfectly competitive model
Although we rarely find instances where all the conditions for pure competition are met, the foreign exchange market displays many of these characteristics. For example, in this market there
are a large number of banks (or dealers) active in the market, each bank holding a very small
share of the total volume of currencies traded on the market. The currencies sold by any bank
are exactly the same in every respect as those sold by any other bank. Competition is concentrated on the price at which a deal is made. The only reason to buy from one bank rather than
another is the price at which the deal can be made. Dealers are constantly in search of low prices at which to buy and high prices at which to sell. The dealers depend on having access to any
information which could impact upon the foreign exchange market. Dealers face banks on
screens which can report the latest news from around the world. If banks make abnormal profits, this should attract new entrants into the market. Dealers can make high profits but can also
make losses. Banks are able to set up more dealers fairly quickly if they wish so.
Similarly, in the market for company shares each share is exactly the same as all other shares of
that company so that buying from one dealer is entirely dependent on price. There are many
dealers. But freedom of entry could be a problem. Commodity markets such as the markets for
copper or tin and some agricultural markets such as those for corn, coffee and tea also broadly
possess the desired characteristics. These products may not all be the same but can be graded to
establish products of specific qualities. Products within certain grades will then trade for the
same prices. Electronic marketplaces such as the Amazon often satisfy the conditions of pure
competition.
What is the relevance of the perfectly competitive model?
Many economists regard it as a useful benchmark against which the competitiveness of realworld markets can be measured. Perfect competition, therefore, gives a basis for comparison of
pricing and performance of firms in more typical (imperfectly competitive) market structures
such as oligopoly and monopolistic competition. In other words, although it is a concept not
likely to occur in the real world, it serves as an ideal or a standard by which to judge other kinds
of industry or market structures. In addition, it serves as an ideal towards which governments
try to shift the economy. Indeed, it might be said that one of the government’s objectives is to
see that the economy’s various industries perform to the greatest possible extent according to
standards exhibited by perfect competition. For example, the conditions necessary for perfect
competition, such as, freedom of entry and exit, and perfect knowledge are often promoted by a
government seeking to improve the efficiency of the economic system.
What is the role of the internet in a market?
The Internet has substantially reduced the type of imperfections that currently prevent many
markets from operating at a competitive equilibrium. By allowing consumers and suppliers to
meet in the same virtual place at minimal cost, the Internet has weakened enormously the immobility problem that has so often impaired the access of buyers to the full range of sellers within
the market. Furthermore, by allowing vast quantities of information to be accessed and processed quickly, Internet sites have presented consumers with an enormously enhanced ability to
compare prices. Within few seconds buyers will be able to get a quote based on aspects such as
speed of delivery and length of warranties as well as that of price.
By providing market information, the Internet makes it easier to find the best deal and to process
transactions with lower transaction (e.g. administration) costs. Since the Internet helps all businesses to reduce costs, it should reduce the minimum efficient scale or optimal size of firms.
Thus one significant barrier to the entry of firms into markets will be reduced.