Question number 3
A. Perfect Competition and Short-Run Economic Profit
Perfect competition, a cornerstone of economic theory, is a market structure characterized by a large number of small firms, homogeneous products, and free entry and exit Augier, M., & Teece, D. J. (Eds.). (2018). In this market structure, firms are price takers, meaning they have no control over the market price. They can sell as much as they want at the prevailing market price. This market is the best choice for customers as they can get the product at the fair price offered by the market. If a firm attempts to increase its price without corresponding value addition, consumers, acting rationally in their self-interest, are likely to substitute towards alternative sellers offering similar products at lower prices Elder-Vass, D. (2019). This consumer behavior exerts downward pressure on the firm's price, compelling it to adjust its pricing strategy to align with market expectations and maintain its competitive position. This dynamic illustrates the inherent self-regulating mechanisms present in competitive markets Gerpott, T. J., & Berends, J. (2022. Phoebe, an Australian bread company, operates in such a market. It has no influence over the price of its bread, and it must accept the market price determined by the forces of supply and demand1. This is a fundamental characteristic of perfect competition, where individual firms’ actions do not affect the market price.
In the short run, a firm like Phoebe can achieve economic profit. This is a scenario where the firm's total revenue surpasses both its explicit and implicit costs. Explicit costs are the direct costs of production, such as wages and raw materials, while implicit costs include the opportunity costs of the resources used in production Sloman, J., Norris, K., & Garrett, D. (2013). This situation arises when the price (P) is above the average total cost (ATC) at the output level that maximizes profit. The firm will maintain production where the marginal cost (MC) equals the marginal revenue (MR), provided P > ATC. This is because, in the short run, a perfectly competitive firm maximizes profit by producing the quantity of output at which the price of the product equals the marginal cost of the last unit produced. So as long as the cost of a bread produced remains less than the price of the bread, Phoebe will keep producing it.
However, it’s important to note that economic profit in the short run is not guaranteed in a perfectly competitive market. It depends on the relationship between the market price and the firm’s average total cost. If the market price falls below the average total cost, the firm will incur an economic loss. Another factor is demand, if the demand of a product is less at a certain price, the supply has to be limited in order to meet the demand thus affecting the overall economic profit.
B. Long-Run Transition and Market Entry
In a perfectly competitive market, the shift to the long run is characterized by the influx of new competitors, a phenomenon that is propelled by the existence of economic profits. When firms within an industry are generating economic profits, it lures new firms to join the industry. As these new firms make their entry, the supply curve experiences a rightward shift, leading to a reduction in both price and profits. This cycle continues until the economic profits dwindle to zero1, as in the long run, a firm has the liberty to modify all of its inputs Lambson (1992).
The transition to the long run also involves changes in the costs of the factors of production. In the long run, output prices will change by the full amount of the change in production cost. A change in fixed cost will also affect price and output in the long run under perfect competition. In the long run, perfect competition results in the achievement of maximum efficiency Augier, M., & Teece, D. J. (Eds.). (2018). It is used as the basis against which to measure market performance for other theoretical and real-world market structures and other economic concepts.
In conclusion, the transition to the long run in a perfectly competitive market involves the entry of new firms, changes in the costs of the factors of production, and changes in price and output. This transition is driven by the goal of achieving zero economic profits and maximum efficiency.
C. Cartel Formation and Its Implications
Cartels are created as a combination of independent firms producing similar goods or services. As a result, they attain an agreement to act as a single producer, controlling supply, fixing prices, and manipulating other market conditions Levenstein, M., & Suslow, V. (2012). Collusion has equally great consequences for social welfare, just as monopolistic firms Damgaard, M. T., Ramada, P., Conlon, G., & Godel, M. (2011). Firstly, the price of goods or services under cartel conditions is usually higher. By fixing prices and supply levels, cartel members create artificial prices. As a result of the changes, consumer surplus tends to fall. Consumer surplus is the amount of money people end up paying for goods or services more than they would in a perfectly competitive market. Secondly, cartels can lead to inefficient allocation of resources Lee, J. S., & Lee, J. S. (2016). In a perfect competitive market, resources are allocated based on supply and demand. However, in cartels, companies can manipulate supply to maintain high prices, which results in excessive allocation of resources to cartelized industries. This can lead to improper allocation of resources at macroeconomic level, thereby reducing overall economic efficiency. Thirdly, the establishment of cartels can inhibit innovation and competition. Cartels by their very nature reduce competition on the market. This lack of competition can hinder innovations, as companies have less incentive to improve their products and services to gain competitive advantage. This can lead to a reduction in dynamic efficiency, an essential element of social welfare. Finally, the establishment of cartels can have a long-term impact on social welfare. Although cartels can bring short-term benefits to the companies concerned, in the long term they can cause market instability. If a cartel collapses, it can cause market disruption, price volatility and potentially harmful impacts on employment.
References
Augier, M., & Teece, D. J. (Eds.). (2018). The Palgrave encyclopedia of strategic management. London: Palgrave Macmillan.
Sloman, J., Norris, K., & Garrett, D. (2013). Principles of economics. Pearson Higher Education AU.
Elder-Vass, D. (2019). No price without value: towards a theory of value and price. Cambridge Journal of Economics, 43(6), 1485-1498.
Gerpott, T. J., & Berends, J. (2022). Competitive pricing on online markets: a literature review. Journal of Revenue and Pricing Management, 21(6), 596-622.
Lambson, V. E. (1992). Competitive profits in the long run. The Review of Economic Studies, 59(1), 125-142.
Augier, M., & Teece, D. J. (Eds.). (2018). The Palgrave encyclopedia of strategic management. London: Palgrave Macmillan.
Levenstein, M., & Suslow, V. (2012). Cartels and Collusion. In The Oxford Handbook of International Antitrust Economics, Volume 2.
Damgaard, M. T., Ramada, P., Conlon, G., & Godel, M. (2011). The Economics of Cartels: Incentives, Sanctions, Stability, and Effects. Journal of European Competition Law & Practice, 2(4).
Lee, J. S., & Lee, J. S. (2016). Defining a Cartel and Analyzing Its Effects. Strategies to Achieve a Binding International Agreement on Regulating Cartels: Overcoming Doha Standstill, 9-61.