RJC Promo 98 Q4 *Distinction Essay*(sorry the graphs are all gone)

Is perfect competition always a more desirable market structure than monopoly? [25m]

Perfect competition (PC) is a market structure where there a large number of buyers and sellers such that no individual buyer or seller can influence demand, supply or price. All firms sell homogeneous products. The firm is a price taker. It faces a perfectly price elastic horizontal demand curve, as shown in Figure 1(a). Marginal revenue (MR) equals average revenue (AR) which is also equal to price. There is perfect information and free entry and exit into the market due to perfect mobility of resources.

On the other hand, there are many buyers but only one seller in monopoly. The monopoly sells a unique product which has no close substitutes. It is a price maker and can affect price or output but not both. It faces a price inelastic demand curve, as shown in Figure 1(b). AR lies above MR. There is imperfect knowledge due to market failure. Strong barriers are also present.

When evaluating which is a more desirable market structure, we should consider their economic efficiency. Resources are said to be allocated efficiently when no one can be made better off without making one other person worse off. From society’s point of view, this occurs at the socially ideal level of output. Efficiency in allocation of resources is known as pareto optimality or pareto efficiency. This can be attained when both productive and allocative efficiency are achieved

Productive efficiency requires that whatever output is being produced, it is being produced at the lowest possible costs. A firm is said to be productive efficient if it produces at the minimum point of its long-run average cost (LRAC) curve. Under this situation, there is efficient allocation of resources, all economies of scale are realized and all diseconomies of scale are avoided. When the firm allocates resources at the most efficient manner possible, full productive efficiency is attained.

PC firms can achieve at productive efficiency as it can produce at the P=AR=minimum point of LRAC=minimum point of short run average cost curve at long run equilibrium. Refer to Fig. 2(a). Under such a situation, it incurs the lowest cost possible and utilities plant size at the optimum. Consumers pay the lowest possible price possible as only normal profits can be made in the long run.

However, the monopolist can make supernormal profits in the long run. But it can never achieve productive efficiency as it can never produce at the minimum point of its LRAC. Instead, it always produces at the falling portion of LRAC, when it is making normal profits. Refer to Fig. 2(b). Hence, it can never achieve optimum level of output. Equilibrium price is at OPe and equilibrium output is at OQe, which is less than the optimal level. There is excess capacity.

Harvey Leibenstein states that the term x-inefficiency is associated with inefficiency such as overstuffing, inability to keep up-to-date technologically and to the slack management of monopoly firms. This means that the firm produces at a cost greater than the lowest possible costs. Due to absence of competition from rivals, the monopolist may not be forced to produce at the lowest possible costs. Hence, x-inefficiency may result in productive inefficiency.

X-inefficiency makes the AC and MC curves higher. Refer to Fig.3. If a firm produces at an average cost of AC₁, when it ought to produce at the lowest possible costs at AC₀, there is x-inefficiency. Comparatively, PC firms do not face this problem.

Allocative efficiency refers to price (P) = marginal cost (MC). This means society’s valuation of the last unit of goods is equal to the opportunity cost of producing the good. There is no allocative allocation of resources and resources are used optimally to meet consumers’ demand. Society’s welfare is at maximum.

Refer to Fig. 2(a). A PC firm can achieve allocative efficiency. However, due to its downward sloping demand curve, the monopolist cannot produce at the point P=MC. Price is greater than MC instead. Thus, it cannot achieve allocative efficiency.

Assuming that the monopoly and the entire PC industry face the same demand curves, Fig. 4 is obtained when the two curves put together. Assuming constrained costs and producing at MC=MR, the monopolist produces at OP_m and OQ_m. There is a dead weight loss of ABE which comprises of loss of consumers and producers’ surplus which is not gained elsewhere.

For the PC industry, MC is the summation of all the PC firms. Hence, where it costs AR, it is the market price. Thus, equilibrium price is at OPc and equilibrium output is at OQc.

Comparing the two, the monopolist equilibrium output is lesser but the price is higher than that of PC. Thus it can be said that the consumer actually benefit less from the monopoly than PC as it, actually pays more but obtain less of the goods. Moreover, productive and allocative efficiency can be achieved under PC but not under monopoly. However, this does not imply that the monopoly is always a less desirable market structure than PC in certain aspects and the PC does have its shortcomings.

The PC firms are small and cannot reap internal economies of scale. However, the monopoly can produce at larger output and reap internal economies of scale. Thus it can lower its MC curve and shift it to MC, as shown in Fig. 4. Hence, it is possible for it to produce at a lower price (OPs) and larger output (OQs) than PC.

Moreover, monopolies sometimes do produce out in interest of the public. Natural monopolies such as those providing water and electricity can produce at high output and charge a lower price. A typical LRAC of a natural monopoly is shown below

Moreover, PC firms may not entail the use of the most efficient productive techniques due to its small size and inability to make supernormal profits in the long run. Thus, this market structure is not conducive for the improvement of existing products or the creation of new ones.

On top of that, pareto optimality can only be achieved under PC when there are no externalities present. The profit seeking activities of producers will bring about allocation of resources that is considered efficient at MC=MR only if marginal costs embodies all forms of costs incurred and price reflects all the benefits that are obtained from the good’s production only when at MC=MR will total sacrifices balance all satisfaction and society’s welfare is at maximum. If tiny external costs or benefits are not reflected by the price system, then production at MC=MR will not result in efficient allocation of resources.

In conclusion, there is no one model that is superior to the other. Thus it cannot be said that PC is always a more desirable market structure than monopoly. Each market structure has its own strengths and weaknesses and each benefits society to a certain extent.

By: Hong Minmin 1S06A

Courtesy of RJC economic department website

posted by Anonymous @ 5:49 PM