Theme 3.4 Flashcards
What is efficiency?
Efficiency can be used to judge how well the market allocates resources, and the relationship between scarce inputs and outputs. There are a range of different types of efficiency.
What is allocative efficiency?
This is achieved when resources are used to produce goods and services which consumers want and value most highly and social welfare is maximised. It will occur when the value to society from consumption is equal to the marginal cost of production, where P=MC.
What is productive efficiency?
A firm has productive efficiency when its products are produced at the lowest average cost so the fewest resources are used to produce each product. The minimum resources are used to produce the maximum output. This can only exist if firms produce at the bottom of the AC curve, in the short run this is where MC=AC. It is only possible if there is technical efficiency, where a given output is produced with minimum inputs- but not all technically efficient firms are productively efficient.
What is dynamic efficiency?
This is achieved when resources are allocated efficiently over time. It is concerned with investment, which brings new products and new production techniques. The alternative is static efficiency: efficiency at a set point in time. Allocative and productive efficiency are examples of static efficiency. Dynamic efficiency will be achieved in markets where competition encourages innovation but where there are differences in products and copyright/patent laws. Supernormal profit is required to provide firms with the incentive to invest and the ability to do so.
What is x-inefficiency?
If a firm fails to minimise its average costs at a given level of output, it is X-inefficient and there is organisational/management slack. This is a specific type of productive inefficiency as it occurs when they fail to minimise their cost for that specific output. It often occurs where there is a lack of competition so firms have little incentive to cut costs, or can also occur because the most efficient capital technologies aren’t being used.
Where does productive efficiency occur?
This occurs where ATC is at its lowest, where MC=ATC.
Where does allocative efficiency occur?
This is where the price (marginal utility) = marginal cost. However, the firms will not necessarily produce at this point if their profits are not maximised at that level of output. This means that there is often an inefficient allocation of resources because the output where the maximum social welfare would be provided isn’t being supplied.
What is perfect competition?
Perfect competition is a market where there is a high degree of competition, but the word ‘perfect’ does not mean it maximises welfare or produces ideal results. There are few industries which fit this type of market structure, one example may be agriculture but government interferences may prevent it from being so. In reality, the assumptions made rarely hold and no market is completely perfectly competitive.
What characteristics must there be for a market to have perfect competition?
-There must be many buyers and sellers
-There must be freedom of entry and exit from the market.
-There must be perfect knowledge of the market.
-The product must be homogenous.
Why must a perfect competition market have many buyers and sellers?
There must be many buyers and sellers. This means that no one firm or customer will be able to influence the market. For example, the decision of one firm to double their output or the decision of one buyer to double their consumption will have no effect. If the firm did manage to have an effect, this would mean the market was no longer perfectly competitive as there would be one large firm and other smaller firms, or one large buyer and other smaller buyers.
Why must a perfect competition markets have freedom of entry and exit from the industry?
This is important as it means that when a business is making profits anyone can enter that market and start producing that product for themselves. As a result, business are unable to make huge profits in the long run and if they are making losses they are able to leave. In the long run, they make normal profits.
Why must there be perfect knowledge for a market to have perfect competition?
This enables firms to know when other firms are making profits which will attract them to join the market. Moreover, all firms have the same costs as they can use the same production techniques. It also means that any attempt to raise prices above the level determined by the market will lead to no sales, as customers will be aware they can buy the same good for a lower price and firms know there is no point lowering the price as they will sell all their goods at the higher price determined by the market.
Why must products be homogenous for a market to have perfect competition?
The product must be homogenous, where they are identical so it is impossible to tell the difference between one make and another e.g. semi-skimmed milk. This is important because it means if a firm raises it price above the competitors’ no one will buy it and they will not gain from lowering their price because they can sell all of your product at the same price as everyone else.
What is the difference between short run and long run for firms in a perfect competition market?
Firms are assumed to short run profit maximise and so the firm will produce at MC=MR. In the short run, it is possible for the firm to make a normal profit, a supernormal profit or a loss. However, firms in perfect competition can only make normal profit in the long run.
Why do all firms in a perfect competition market make normal profit in the long run?
Prices are set by the market at P1, where S1=D1. As a result, the firm faces the demand curve of AR1=MR1 and produce where MC=MR1 at Q1 goods. However, since there is perfect information and ease of entry, the fact they are making supernormal profits will encourage new entrants to the market. This will increase supply from S1 to S2 and lead to a fall in price from P1 to P2. The firm now has the demand curve AR2=MR2 and produces where MC=MR2 at Q2. This is also where AR2=AC and so they are making normal profits. If the firm was making a loss, firms would leave the industry and this would decrease supply, pushing prices up and reverting to the long run equilibrium.
How can you deduce the short-run supply curve from the marginal cost curve?
The short run supply curve will follow the marginal cost curve until you reach the point where AVC>P, as this is the shut-down point and after this there will be no supply as production will stop.
Why is perfect competition static efficient in the long run?
Perfect competition is productively efficient, since they produce where MC=AC. They are also allocative efficient since they produce where P=MC. Thus, they are static efficient.
Why is perfect competition not actually dynamically efficient?
However, they are not dynamic efficient. No single firm will have enough for research and development (as there is no SNP) and small firms struggle to receive finance. The existence of perfect information also means one firms’ invention will be adopted by another firm and so the investment will give the firm no competitive benefit. Governments tend to have to do all the research.
Why may costs be higher in perfect competition than they could otherwise be?
Competition should keep costs, and therefore prices, low. However, firms will be unable to benefit from economies of scale and this may mean costs are higher than they otherwise could be.
Why does perfect competition not occur in reality?
-All firms will actually hold some price-setting power in reality.
-Complex products means that consumers won’t actually have perfect market knowledge
-No goods are completely homogenous, some brands will also hold a better reputation than others.
-Regulation set out by governments as well as fixed costs required for certain capital means that there isn’t actually free entry and exit into a market.
What is monopolistic competition?
Monopolistic competition is a form of imperfect competition, with a downward sloping demand curve. It lies in between the two extremes of perfect competition and monopoly, both of which rarely exist in a pure form in real life. Some examples of firms in monopolistic competition are hairdressers, estate agents and restaurants.
What are the characteristics of monopolistic competition?
-There must be a large number of buyers and sellers in the market, each of whom are relatively small and act independently. This means that no one buyer or seller has a large price setting power.
-There are no barriers to entry or exit, allowing new firms to enter when supernormal profits are being made and some to leave in the case of losses. As a result, only normal profits can be made in the long run.
-The difference between monopolistic competition and perfect competition is that in monopolistic competition firms produce differentiated, non-homogenous goods or services. This means that individual firms do have some price setting power, and so the curve is downward sloping.
What is the difference between the available profits in monopolistic competition in the short run vs long run?
In the short run, firms can make supernormal profits, losses or normal profits. However, due to the lack of barriers to entry/exit, firms can only make normal profits in the long run.
Why can supernormal profits not be made in the long run in monopolistic competition?
Firms are assumed to be short run profit maximisers, producing at MC=MR1 in the short run. As a result, they produce Q1 at price P1 and make a supernormal profit of the shaded area. However, in the long run, new firms will enter the industry as they know that supernormal profits are being earnt. This will cause demand for the individual firm to decrease and therefore the AR and MR curves will shift to the lift. The firm will produce where MC=MR2 at P2Q2. At this point, AC=AR2 and so the firm is making normal profits. If the firm was making a loss, firms would leave the industry and thus demand for the individual firm would increase as they had less competition. This would lead to normal profits in the long run.