What are the Benefits of Perfect Competition?

Very few markets or industries in the real world are perfectly competitive. For example, how homogeneous is the output of real firms, given that even the smallest of firms working in manufacturing or services try to differentiate their product.

The assumption that producers and consumers act rationally is questioned by behavioural economists, who have become increasingly influential over the last decade. Numerous experiments have demonstrated that decision making often falls well short of what could be described as perfectly rational. Decision making can be biased and subject to rule of thumb ‘guidance’ when consumers and producers are faced with complex situations.

Although unrealistic, it is still a useful model in two respects. Firstly, many primary and commodity markets, such as coffee and tea, exhibit many of the characteristics of perfect competition, such as the number of individual producers that exist, and their inability to influence market price. Secondly, for other markets in manufacturing and services, the model is a useful yardstick by which economists and regulators can evaluate levels of competition that exist in real markets.

The benefits of the Model of Perfect Competition

It can be argued that perfect competition will yield the following benefits:

1.  Because there is perfect knowledge, there is no information failure and knowledge is shared evenly between all participants.

2.  There are no barriers to entry, so existing firms cannot derive any monopoly power.

3.  Only normal profits made, so producers just cover their opportunity cost.

4.  There is no need to spend money on advertising, because there is perfect knowledge and firms can sell all they can produce. In addition, selling unbranded goods makes it hard to construct an effective advertising campaign.

5.  There is maximum possible:

o    Consumer surplus

o    Economic welfare

6.  There is maximum allocative and productive efficiency:

o    Equilibrium will occur where P = MC, hence allocative efficiency.

o    In the long run equilibrium will occur at output where MC = ATC, which is productive efficiency.

7.  There is also maximum choice for consumers.

Perfect Information Vs. Complete Information

Perfect information in economics is used to describe a subset of Perfect Competition.

With perfect information in a market, all consumers and producers are assumed to have perfect knowledge of price, utility, quality and production methods of products, when theorizing the systems of free markets, and effects of financial policies.

Perfect information is also a game situation in which an agent is theorized to have all relevant information with which to make a decision. It has implications for several fields.

Complete information is a term used in economics and game theory to describe an economic situation or game in which knowledge about other market participants or players is available to all participants. Every player knows the payoffs and strategies available to other players.

Complete and perfect information are importantly different. In a game of complete information, the structure of the game and the payoff functions of the players are commonly known but players may not see all of the moves made by other players (for instance, the initial placement of ships in Battleship); there may also be a chance element (as in most card games). Conversely, in games of perfect information, every player observes other players' moves, but may lack some information on others' payoffs, or on the structure of the game.

Games of incomplete information arise most frequently in social science rather than as games in the narrow sense. For instance, Harsanyi was motivated by consideration of arms control negotiations, where the players may be uncertain both of the capabilities of their opponents and of their desires and beliefs. Games of incomplete information can be converted into games of complete but imperfect information under the "common prior assumption." This assumption is commonly made for pragmatic reasons, but its justification remains controversial.

Complete Vs. Incomplete Information

In a game of complete information all players' are perfectly informed of all other players payoffs for all possible action profiles. Examples will be the Game of chicken, Prisoner's dilemma, chess, checkers etc. In all the above the players know about each others' utility function/payoffs. If instead a player is uncertain of the payoffs to other players the game is one of incomplete information. In an incomplete information setting players may not possess full information about their opponents. In particular players may possess private information that the others should take into account when forming expectations about how a player would behave. Examples would be situations such as buying auto insurance, playing blind poker etc.

Questions:

1. What should a buyer know about the seller in order to make  decisions?

2. What should the seller know about the seller to make seller 

related decisions?

3. In India, what are the ways by which buyer and seller deceive? 

4. What are the steps taken by Government to increase use of information / knowledge and awareness?   

Just thinking on the above given points may take you to several issues related to modern markets. Do share your observations / opinions on this important issue. 

Contestable Markets: A Model in Perfect Competition

A contestable market occurs when there is freedom of entry and exit into the market. Thus in a contestable market, there will be low sunk costs.(Costs which can’t be recovered when leaving the market)

When considering the contestability of markets it is important to consider the different barriers to entry a new firm may face

1.  Sunk Costs. If Sunk costs are high this makes it difficult for new firms to enter and leave the market. Therefore it will be less contestable.  For example, if a new firm had to purchase raw materials, that it wouldn’t be able to resell on leaving the market, this may act as a deterrent.

2.  Levels of advertising and brand loyalty.  If an established firm has significant brand loyalty such as Coca Cola, then it will be difficult for a new firm to enter the market. This is because they would have to spend a lot of money on advertising which is a sunk cost.  Even if they spend money on advertising it may not be sufficient to change customer loyalty to very strong brands. It depends on the industry, customer loyalty would be fairly low for a product like petrol because it is quite homogeneous. But, for soft drinks people have greater attachment to their ‘brand’

3.  Vertical Integration If a firm does not have access to the supply of a good then the market will be less contestable. E.g. Oil firms could restrict the supply of petrol to petrol stations, making it difficult for new firms to enter. If you wish to sell electricity to domestic customers, a big issue is whether you can gain access to the electricity grid. The national electric grid is a natural monopoly, but government regulation can make sure firms have a fair access to the grid. Giving access to different stages of production can make the market more contestable. (How vertical barriers can restrict competition)

4.  Access to technology and skilled labour For some industries like car production it is difficult for new firms to have the right technology. Nuclear power may require skilled labor that is difficult to get. This makes the market less contestable. If you wished to compete with Google, you may find it hard to employ the best software engineers because Google pays its employees a very good wage and is seen as an attractive company to work for.

See also: other barriers to entry

As well as looking at barriers to entry, there are other factors that might indicate the competitiveness of a market.

·    The level of profit. If the market is  highly profitable, this suggests the market is less contestable. In theory, if firms are making supernormal profit, it would attract new firms into the market. The persistence of supernormal profits suggests that hit and run competition is not possible and there are barriers to entry.

·       The number of firms. A contestable market could have a low number of firms – as long as there is the threat and possibility of new firms entering. However, if there are only a few firms and it has been many years since any new firms have entered, then it is likely to be less contestable. If there are recent examples of firms entering the market, then it is likely to be more contestable.

It is important to remember that contestability is not a clear cut issue, there are degrees of contestability, some markets having more capacity for new firms to enter. In practice few industries are perfectly contestable.

Example – UK Banking industry

1.  There are high sunk costs in getting a network of banks set up around the country..

2.  Brand loyalty to existing banks is high. Customers are not so willing to switch. Therefore a new firm may have to spend a lot on advertising to attract new customers, which is a sunk cost, therefore not contestable.

3.  Existing banks make very high profits, suggesting hit and run competition does not occur.

These issues suggest banking is not contestable. However, other factors may suggest greater contestability.

·     The introduction of the internet has reduced set up costs and enabled new firms to enter the market for online banking e.g. EGG, Virgin business.

·     The government is trying to introduce regulation to reduce the time and costs of switching to another current account.

Contestable Markets and the public interest

Contestable markets can bring the benefits of competitive markets such as:

· Lower prices

·  Increased incentives for firms to cut costs

· Increased incentives for firms to respond to consumer preferences

However there could also be significant economies of scale because the theory of contestable markets doesn’t require there to be 1000s of firms

·   Therefore policy makers should not just look at the degree of concentration, but also the degree of contestability and how easy it is to enter the market.

·   Regulators in the privatized industries have often focused on removing barriers to entry, rather than breaking up big firms

Methods to Increase the Contestability of Markets

1.  Remove legal barriers to entry. Royal Mail used to be a legal monopoly but now firms are allowed to enter the market for sending letters and parcels.

2.  Force firms to allow competitors to use its network For example when BT was privatised, OFTEL forced BT to allow other companies to use its network. This has also occurred in the Gas and Electricity industries and has made them more contestable. A firm can now gain access to the national network of gas / electricity infrastructure

3.  Legislation against Predatory Pricing If a firm can engage in predatory pricing it can force new firms out of business and make it less contestable.

4.  OFT can legislate against abuse of Monopoly power. If a firm abuses its monopoly power by restricting supply to certain firms the OFT can intervene to overcome this restriction on contestability.

5.  A government firm. In the banking industry, the government has even toyed with creating its own company to help increase competition and increase bank lending to small firms. This could be a last resort where private firms face insurmountable barriers to entry.

Note, there are many barriers to entry that the government can’t solve. The government can’t alter the economies of scale in an industry.

Article from: Economics Help Blog

PERFECT COMPETITION - EXPLANATORY NOTES

Perfect competition is a type of market characterized by
- a very large number of small producers or sellers,
- a standardized, homogeneous product,
- the inability of individual sellers to influence price,
- the free entry and exit of sellers in the market, and
- unnecessary nonprice actions.

Examples of markets in perfect competition are extremely rare. Numerous markets in the retail, service and agricultural sectors approach perfect competition best. But, in the agricultural sector, government support price programs distort the market mechanism. Notwithstanding the lack of good examples, this form of market is important because of a general conviction among economists that it is the best form of market.

PERFECT COMPETITION NUMBER OF FIRMS
The very large number of firms in perfect competition implies
that each individual firm is very small in comparison to the
total market. Indeed, if one firm were to become significantly
large, it would dominate the market and competition would be
eliminated or at least diminished.

In the milk production segment of agriculture, farms are usually small. They are especially small compared to the size of the entire market for milk. Note that the milk distributors are occasionally large, but not the productive farms.

PERFECT COMPETITION STANDARDIZED PRODUCT
The product in perfect competition is said to be standardized
(or homogeneous). This means that it does not make any
difference to customers which specific firm sells the product:
it is absolutely identical. This is the main distinction
between perfect competition and monopolistic competition: once
some differences can be recognized by customers, firms acquire
power over these customers.

Milk is a uniform and homogeneous product. It is not possible to make a distinction between the milk of one farm and another. The government has indeed set standards of quality, fat content and cleanliness.

PRICE TAKER
The firms in perfect competition have no power over price: they
have to sell at the going market price. The firms in perfect
competition are said to be price takers. Should a firm attempt
to raise the price by the smallest possible amount, customers
would not buy from it because they could buy the same product
from other firms. Lowering the price is also not necessary
because the firm can already sell all its output at the going
price.

A milk producer who would try to raise his/her revenues by increasing the price for milk, would find the company collecting the milk in that region unwilling to buy his/her milk any longer. One individual farmer is thus unable to affect the price of milk in the entire market.

PERFECT COMPETITION ENTRY AND EXIT
There are no barriers to entry to or exit from a market in
perfect competition. This condition assures that no firm will
dominate the market and evict other firms. It also assures that the
number of firms (although changing) will remain large.

Agricultural production can start for most crops by simply planting on a parcel of land. For instance, that is true for fruit trees and vegetables. (It is true. however, that for some products such as milk or tobacco, the government limits production because of the existing overproduction).

PERFECT COMPETITION NONPRICE ACTION
Nonprice actions such as advertising, service after sale or
warranty, are not necessary in perfect competition because
the firm can already sell all its output at the going price, and
incurring additional expense would only make it unprofitable.
(Nonprice action for the entire industry may however be useful).

A single milk producer cannot possibly influence the consumption of milk at large, and needs not advertise. An association of milk producers or a large milk distributor may, however, be in a position to use advertisement effectively.

PERFECT COMPETITION DEMAND
The demand of firms in perfect competition is perfectly elastic
(i.e., the smallest possible price change results in a
virtually infinite quantity change). Such demand is represented
graphically by a horizontal demand curve: no matter what
quantity is sold, the price is the same, and it is the going
price in the market.

Nationwide, the demand for milk is likely to be downsloping, that is inversely related to price. But for a single milk producer, it is given by the price the farmer can receive: the going market price. It does not change, no matter what quantity the farmer produces. Thus demand is horizontal.

PERFECT COMPETITION MARGINAL REVENUE
The horizontal demand curve is also the marginal revenue of a
firm in perfect competition. The marginal revenue, or
additional revenue from one more unit sold, is just equal to
the going price (which is shown graphically by the demand curve
itself). Note that the average revenue is also the demand curve
and total revenue is an upsloping straight line.

PROFIT MAXIMIZATION
A firm must seek to sell a volume of output where its total
revenue exceeds its total cost by the largest amount possible;
that is, its profit is the maximum.

LOSS MINIMIZATION
If a firm fails to derive a profit, it may nevertheless seek,
in the short run, to produce at that level of sales where the
difference between its cost and its revenue, i.e., its loss,
is minimum.

CLOSE DOWN DECISION
If a firm has revenues that are insufficient to cover even its
fixed costs in the short run, the firm must close down.

BREAK-EVEN POINT
The volume of output where total revenue is equal to total cost
is known as the break-even point. A firm must be beyond its
break-even point in order to be maximizing its profit.

MARGINAL REVENUE MARGINAL COST RULE
Producing at the level of output where marginal revenue equals
marginal cost is equivalent to profit maximization. Indeed, if
one less unit were to be produced, profit would be smaller by the
excess of marginal revenue over marginal cost for that last
unit. If one more unit were to be produced, profit would also be
smaller, this time by the excess of marginal cost over marginal
revenue.

MARGINAL REVENUE MARGINAL COST
The marginal revenue = marginal cost rule is applicable to
loss minimization as well as profit maximization. However, if
marginal revenue intersects marginal cost below average
variable cost, it means that revenues are not sufficient to
cover fixed costs and the firm should close down.

MAXIMUM PROFIT
The maximum profit is obtained by first determining the level
of output for which marginal revenue equals marginal cost (thus
profits cannot possibly be increased). Then determining
1- total revenue given by price multiplied by quantity,
2- total cost given by average total cost multiplied by
quantity,3- the difference between 1 and 2 above is the profit (or loss).

MAXIMUM PROFIT GRAPH
Since maximum profit is the excess of total revenue over
total cost, it is shown graphically as the area by which the
total revenue rectangle exceeds the total cost rectangle. The
height of total revenue rectangle is the price received by the
firm, and the width is the optimum quantity (where MR=MC). The
height of total cost rectangle is average total cost (on ATC
curve), and the width is the optimum quantity.

SHORT RUN SUPPLY CURVE
The short run supply curve of firms in perfect competition is
the upsloping portion of the marginal cost curve (above the
average variable cost intersection). Indeed, a firm determines
its optimum volume of sales by taking the intersection of
marginal revenue and marginal cost. The marginal revenue is also
the price it receives. Thus supplier's price-quantity
combinations are given by the marginal cost upsloping portion.

LONG RUN PERFECT COMPETITION EQUILIBRIUM
The long run equilibrium for firms in perfect competition
is where demand (and marginal revenue which is identical to it)
is tangent to the minimum of average total cost (where marginal
cost also intersects average total cost). At that point, there
is no profit or loss for the firm. (Note that there is no pure
or economic profit, but normal profit must still be covered).

ENTRY OF FIRMS IN PERFECT COMPETITION
Should demand be above the minimum of average total cost, pure
profit would exist for firms in perfect competition. This profit
would attract new firms to the industry. Such entry of new
firms is not impeded by any entry barriers in industries in
perfect competition. The new firms would increase the total
market supply and drive the price down. The lower price pushes
the demand for each firm down toward or even below the
equilibrium minimum average total cost point.

EXIT OF FIRMS IN PERFECT COMPETITION
Should the demand be below the minimum of average total cost,
losses of firms would force some firms to leave the industry.
As firms leave, a decreasing total supply pushes price back up.
The increasing price lifts the demand curves for individual
firms upward toward or even above the equilibrium point. Firms
departure or entry will continue until the price settles to be
just equal to minimum average cost.

LONG RUN SUPPLY CURVE
The long run supply curve for an industry in perfect competition
is perfectly elastic (that is horizontal) in constant-cost
industries and upsloping in increasing-cost industries. Whether
an industry is constant-cost or increasing-cost is determined by
the presence of adequate or insufficient resources.

PERFECT COMPETITION ECONOMIC EFFECT
Perfect competition is seen as an ideal or optimum form of
market because of its very beneficial economic effect for
society, which comes from
- allocative efficiency, and
- productive efficiency.
But there are a few shortcomings nevertheless.

PRODUCTIVE EFFICIENCY
The productive efficiency of perfect competition can be observed
in the long run equilibrium point of all firms in the industry,
which is at the minimum of average total cost. This means that
all firms are forced to cut their costs and utilize the best
available technology in order to have their minimum average
total cost no higher than that of all the other firms in the
industry. There is also no under or over utilized capacity.

ALLOCATIVE EFFICIENCY
The allocative efficiency in perfect competition comes from the
fact that the quantity produced by each firm is just that for
which the price paid by society is equal to the cost of
additional resources (marginal cost). More could not possibly
be obtained for a lower price. The resources are also the most
efficiently allocated among industries since firms will bid for
these resources up to the price consumers want to pay for them.

PERFECT COMPETITION SHORTCOMINGS
In spite of its beneficial economic effect, perfect competition
fails to
- provide any correction for income distribution inequity,
- generate any public goods since there is not profit,
- stimulate technological progress because of lack of profits,
- offer diversity in products since these are standardized.

Case Study: Perfect Competition in Credit Card Industry !

In 1997, over $700 billion purchases were charged on credit cards, and this total is increasing at a rate of over 10 per cent a year. At first glance, the credit card market would seem to be a rather concentrated industry. Visa, MasterCard and American Express are the most familiar names, and over 60 per cent of all charges are made using one of these three cards. But on closer examination, the industry seems to exhibit most characteristics of perfect competition. Consider first the size and distribution of buyers and sellers. Although Visa, Mastercard and American Express are the choices of the majority of consumers, these cards do not originate from just three firms. In fact, there are over six thousand enterprises (primarily banks and credit unions) in the US that offer charge cards to over 90 million credit card holders. One person's Visa card may have been issued by his company's credit union in Los Angeles, while a next door neighbour may have acquired hers from a Miami Bank when she was living in Florida. Creditcards are a relatively homogenous product. Most Visa cards are similar in appearance, and they can all be used for the same purposes. When the charge is made, the merchant is unlikely to notice who it was that actually issued the card. Entry into and exit from the credit card market is easy as evidenced by the 6000 institutions that currently offer cards. Although a new firm might find it difficult to enter the market, a financially sound bank, even one of modest size, could obtain the right to offer a MasterCard or a Visa card from the present companies with little difficulty. If the bank wanted to leave the field, there would be a ready market to sell its accounts to other credit card suppliers. Thus, it would seem that the credit card industry meets most of the characteristics for a perfectly competitive market.

Questions

1. What are the characteristics of perfect competition that are exhibited by the credit card industry?

The characteristics of perfect competition that are exhibited by the credit card industry are:

1.  A large number of small firms,

2.  Identical products sold by all firms,

3.  Perfect resource mobility or the freedom of entry into and exit out of the industry, and

4.  Perfect knowledge of prices and technology.

2. Do you think the same competitive state is applicable to the Indian scenario?

Yes, the same competitive state is applicable to the Indian scenario. The main reason for the growth of credit cards as compared to debit cards is mainly due to provision of overdraft facility which facilitates the customers to make purchases and payment even without having enough money available in their account. The increase in the number of commercial activities and the growing malls in smaller cities have also contributed positively in the rise of credit card market.

Found at: 

• Infinite Soluzioni Blog

Cost of Freedom

Politicians and pundits use the phrase “Cost of Freedom” a lot, usually in reference to something they are asking you to do that you probably prefer not to, such as pay higher taxes, wear a uniform, submit to intrusive surveillance, or simply keep quiet about any doubts you may have about the former.

Before going into the cost of freedom, however, perhaps we need to take a closer look at what we mean by freedom, exactly.

There is no pure, perfect freedom. We all agree that there are certain things we should not be free to do, such as to walk in and out of each others’ homes removing TV sets and jewelry, or shoot the neighbor who is hard of hearing and falls asleep each night in front of the too-loud TV set. We understand and agree to certain rules required to create a society in which specialized skills operate together in mutually beneficial commerce.

So, let us start out by defining a free society not as a society where people are free to do what they wish, but as one in which we freely choose to surrender certain behaviors in exchange for the benefits of living within that society. A covenant exists between the rulers and the ruled in which each freely agrees to follow a set of rules of behavior, in exchange for a certain set of rights. In the United States, that covenant is enshrined in the Constitution and the Bill of Rights, a contract which lays out what the government may, and more importantly may not do.

In a free society, the covenant must be enforced on both the rulers and the ruled equally. To enforce the covenant upon the people there is law enforcement, and when needed, prison. To enforce the covenant on the side of the government, the Founding Fathers created a government of three components, each charged with keeping an eye on the other two, and when needed, to legally restrain excess of authority.

 

Following the collapse of the USSR, the United States Government lost its most potent demon to wave at the masses. But it was quickly replaced with SARS, Aids, Swine Flu, Avian Flu, Ebola, Global Warming, Global Cooling, inflation, deflation, and most recently terrorists. Each and every demon was waved at us to trick us into surrendering more of our money, more of our children’s lives, more of our rights, and each and every demon had no more substance than the paper-mache’ heads used by the Wizard of Oz to trick Dorothy into making war on the Wicked Witch of the West. Fear gave politicians issues to run on, defense and medical corporations markets for their products, and media sensational content for their periodicals and broadcasts.

That it was all trickery and deception with the purpose of tricking us out of our rights was best illustrated by President George W. Bush’s plan to deal with Avian Flu, which not only enriched his good friend Donald Rumsfeld, but also included gun confiscation. It should be noted that firearms (and the second amendment) do not increase one’s susceptibility to infection by viruses. Clearly, the real agenda isn’t to save the populace from a flu virus (which as of this writing has actually killed few humans), but to grab the guns and remove the right to firearms recognized by the Founding Fathers.

The problem with a government that rules by fear is that once they have started to use fear on their own population they can never stop, never allow the fear to subside, never allow the population to calm down and think rationally. Because when the population stops being afraid, when they start to think, they will start asking why they cannot have all the rights, freedoms, and money back. This actually happened following the collapse of the USSR in 1990, when Americans, tired of the trillions in taxes collected and spent on the nuclear deterrent, demanded a drastic reduction in military spending. So, in 1991, the US tricked Saddam Hussein into invading Kuwait by promising they would not object, then invaded Iraq, thereby having a convenient war to keep the military budget inflated.

Today we are in two wars, both of which now appear to have been started with outright lies by the US Government. Americans are starting to say “no” to more wars and that is a good thing, for above all else freedom means the freedom to say “no” to the government,; to remind them that they too are bound by the covenant to restrict their actions to the letter of the Constitution and the laws.

The Cost of that Freedom isn’t paying more taxes or wearing a uniform; it is simply to decide one will not be afraid of the manufactured demons put forth in print and in TV that serve no purpose than to keep the people meek and under control. That is all it takes; the will to not be afraid.

Of course the government does not like people who refuse to live in fear, or who say no. Every time a citizen stands up and says “no” the tyrant fears. Every time a citizen refuses to be afraid the government will work extra hard to make that person afraid, and even today we see those who speak out, because they are no longer afraid, subjected to harassment and intimidation. Yet they remain unafraid, for they see the harassment and intimidation for what it is, a symptom of a government losing control of the people, and they choose to remain unafraid.

So, that’s really all there is to it. Refusing to be afraid. Refusing to be tricked out of your rights.

Freedom is the freedom to say “no”, and the freedom to live your life unafraid.

Article By: Michael Rivero 

Accessible at: http://whatreallyhappened.com/WRHARTICLES/costoffreedom.