Free Markets and Competition Flashcards
Why do economists love competitive free markets?
Because, if they are operating properly, these markets make sure that resources are allocated optimally. In particular, such markets ensure that resources go towards producing only output for which the benefits exceed the costs.
What conditions must be met if free markets are to guarantee optimal outcomes? (1)
Buyers and sellers all have access to the same full and complete info about the good or service. This condition guarantees that both are willing to negotiate without having to worry that the other has secret info.
What conditions must be met if free markets are to guarantee optimal outcomes? (2)
Property rights are set up so that the only way buyers can get the good or service in question is by paying sellers for it. This condition ensures that there are sellers willing to provide the product. As a counter example imagine trying to sell tickets to an outdoor fireworks display - but since everyone knows they can see the display for free, no-one is willing to pay for a ticket. But if sellers can’t sell tickets, they have no incentive to put on a display.
What conditions must be met if free markets are to guarantee optimal outcomes? (3)
Supply curves capture all the production costs that firms incur in making the good or service in question and demand curves capture all the benefits that people derive from the good or service. This condition ensures that a proper cost-benefit calculation can be made.
What conditions must be met if free markets are to guarantee optimal outcomes? (4)
Numerous buyers/sellers exist so that nobody is big enough to affect the market price. This is called the price-taking assumption, because everybody has to take prices as given. This eliminates the problems like monopolies.
What conditions must be met if free markets are to guarantee optimal outcomes? (5)
The market price is completely free to adjust to equalise supply and demand for the good or service in question. Thus ruling out the chances of government imposed price-ceilings or floors.
What happens if all 5 conditions are met?
Supply and demand automatically achieve the social optimum without the gov or socially conscious activists having to do anything. This was the basis of Adam Smith’s invisible hand metaphor - which seems to guide markets to do the right thing despite nobody being in charge - and despite the fact that each individual in the market may well be looking out for only his or her own interests.
How can we use supply and demand to compare costs and benefits?
For one unit of output, people are willing to pay £8 whereas firms are willing to supply this unit for just $2. Producing this first unit is therefore socially beneficial because the value is worth more to buyers (£8) than it costs sellers to produce (£2).
In contrast look at the fifth unit… costs = £6 but benefits only = £4. Therefore this unit of output should not be produced as making it involves converting £6 worth of resources into something worth only £4 to consumers. Producing it destroys wealth.
What are the 3 cost-benefit relationships in our supply and demand curve example?
- For every bit of output where q < 4, benefits exceed costs.
- At exactly q = 4 units, benefits equal costs (the socially optimal level of output i.e. society gains or is atleast not made worse off).
- For every bit of output where q > 4, costs exceed benefits.
What is meant by total surplus?
Total surplus is a concept used to total up the gains that come from producing the socially optimal output level. The gain, or surplus comes from the fact that the benefits exceed costs for the units of output that are produced.
Total surplus is divided between consumer surplus and producer surplus.
What is consumer surplus?
Consumer surplus is the gain people receive when they can buy things for less than what they’re willing to pay. The easiest way to understand consumer surplus is to first consider a discrete good: a good that comes in discrete units i.e. you can buy 1 cow or 57 cows, but you can’t buy 2.35 cows. The demand curves for discrete goods aren’t smooth, downward sloping curves. Instead they are what mathematicians call a step function.
Imagine the market price of a cow is £500. measure the consumer surplus for the first cow (costs = £900), the second cow (£800), the third (£700) etc.
For the first cow the consumer surplus is £400 as they are willing to pay £900 but only pay the market price of £500.
People break evebn on the 5th cow as they’re willing to pay £500 which equals the market price.
Consumer surplus in this case = the total surpluses that people get on each unit that they choose to buy i.e. 400 + 300 + 200 + 100 + 0 = £1000
What does the consumer surplus for cows look like?
What are continuously measured goods and services?
Things like land, cooking oil or hours of music lessons, which aren’t necessarily sold in discrete units. In other words, you can buy fractional amounts of these i.e. 78.5 acres of land or 6.33 litres of cooking oil.
Demand curves for continuously measured goods and services are smooth and downward sloping therefore when you graph consumer surplus you get a triangular area that lies below the demand curve and above the market price.
Using cooking oil as an example, calculate the consumer surplus for a continuous good.
This requires geometry.
Simply use the formula for the area of a triangle (1/2 x base x height)
1/2 x 1000 x 5 = £2,500
What is producer surplus?
producer surplus measures the gain that firms receive when they can sell their output for more than the minimum price that they were wiling to accept
Using a graph for cooking oil, demonstrate producer surplus.
The price of cooking oil = £5. Producers are going to want to supply exactly 1,000 litres at this price. Why? Because for each drop of oil up until and including the 1,000th litre, the production costs as given by the supply curve are less than the £5 per litre that producers get when they sell the oil.
From our cooking oil example, how do we know producers are willing to supply almost all that cooking oil for less than the £5 per litre market price?
This is shown by the fact that the supply curve lies below the horizontal price line up until the very last drop of the 1,000th litre.
The fact that the producers receive £5 per litre in spite being willing to produce it for less, is the source of the producer surplus, which is represented by the shaded area of the triangle.
Producer surplus = area of a triangle = £2000
In other words the producers are £2000 better off by seeling the 1000 litres of oil because the total cash they make from selling these 1000 litres exceeds the minimum amount that they were willing to accept by £2000.
What is total surplus?
The total surplus that society receives from producing the socially optimal level of output of a certain good or service is simply the sum of the consumer surplus and producer surplus generated by that output level.
Why is total surplus importat?
Because it puts a number on the gains that come from production and trade.
i.e. firms make things to make money and people spend money on things to make themselves happier. Total surplus tells you just how much better off noth producers and consumers are after interacting with each other.
Graphically depict how a price ceiling can create a DWL.
Bear in mind, price ceilings are supposed to help buyers obtain a low price.
But at the ceiling price suppliers are only willing to sell qL units of output (low). But if no ceiling price existed, i.e. in a free market, they would produce the market equilibrium quantity of output q* and total surplus would = A, B, C.
But because only qL units can be produced, the total surplus area is reduced to just A, B, F and E.
The difference between these two = the DWL
Show how a tax increase shifts the supply curve.
Imagine the government impose a tax of £1 per kilo of beef sold.
- S* = supply curve for beef
- S + tax =* supply curve after tax is imposed
Following the introduction of a demand curve, show what happens to total surplus when the gov impose a £1 per kilo tax on beef.
Before the tax, the market eq. = point A - producers supply 10 million k of beef at £5 per kilo. Total surplus = C, D and A.
After the tax is imposed, the eq. is at point F. Beef = £5.50 per kilo, and 9 million kilos are supplied. Total surplus reduces to G, D and F.
In our DWL (beef) example, how are tax collections represented, graphically?
Graphically tax collections are represented by the parallelogram C, D, F and E.
This area was once part of the old total surplus triangle, it hasn’t been destroyed, but merely transferred to the government.
In our DWL (beef) example, what part of the old total surplus has been destroyed?
The part that has been destroyed = the DWL (triangle E, F and A).
This captures the fact that society is made worse off by the reduction in beef output from 10 to 9 million kilos.
Using the market for tennis balls, graphically depict how an industry adjusts when it starts off making profits.
On the left we see the S & D curve for tennis balls. On the right we see the cost curves for one of the many identical firms that make tennis balls.
Since all firms are identical they all have identical cost structures and (importantly) identical marginal costs. Remember in PC a competitive firms MC curve is its Supply curve.
In our tennis ball example, what price does the firm take?
The firm in our example takes the market price, P0, determined by supply and demand in the left graph, and uses it to work the profit-maximising output level in the right graph.
To emphasise the P0 is the same in both graphs, we draw a solid horizontal line.
Using the market for tennis balls, graphically depict how new entry reduces profits in an industry.
New production increases overall production so the total supply curve shifts from S0 to S1 in the left hand graph, lowering the market price from P0 to P1.
Each price-taking firm reacts to the lower price by producing a lower output level, q1 (right hand graph) - this decreases the firms’ profits (smaller shaded rectangle).
The new enry reduces profits. Smaller profits are less attractive to entrepreneurs. So although new entry continues (since some profits are still available) that new entry is less than when profits were larger.
Using the market for tennis balls, graphically depict how enough emntry drives profits to zero.
Eventually, even more new entry increases supply to S2 and so market price falls further to P2, which results in zero profits (no shaded profit rectangle exists) and therefore entry ceases.
How do zero profits also bring about minimum cost production?
The output that firms choose to produce, q2, lies exactly at the minimum point on the ATC curve. Here, the average cost per unit is lower than at any other output level. This situation is great because it means that each firm is being as efficient as possible, producing output at the lowest possible cost per unit.
furhtermore, each firm is voluntarily choosing to produce at that level without any need for coercion.
This is truly Adam Smith’s invisible hand at work.
Graphically depict how an industry adjusts when it starts off making losses.
The initial supply curve S3 interacts with the deamnd curve, D, to produce a very low market price of P3.
At this market price, each firm is making a loss (shaded rectangle). this loss discourages all the firms in the industry, and those in the weakest financial condition begin to exit.
What happens once the firms with the weakest financial condition begin to exit?
The industry supply curve shifts left because supply decreases (left hand graph). That shift raises market price and reduces the losses made by firms remaining in the industry.
But as long as losses exist, firms continue to exit until the supply curve moves all the way back to S2 at which point the market price is P2, and firms are making zero profits. in other words, each firm is producing at the least cost output level, q2.
