Explain, and Illustrate Using Graphs
Explain, and illustrate using graphs, whether you think a perfectly competitive industry or a monopoly industry leads to more efficient outcomes for an economy. RESEARCH ESSAY Microeconomics is defined as a study of how economic decisions are made by individuals and groups along with the range of factors affecting those decisions. In relevance to this, the analysis of perfect competition and monopoly regarding efficiency is considered one of the most core basis to the understanding of Microeconomics. This paper argues that a perfectly competitive industry leads to more efficient outcomes for an economy than a monopoly does.
In this essay, I will first define the concept of two market structure types and then go on to explore how they affect the level of efficiency and economic welfare. Alternatively, I will also bring up some exceptions by which this finding may not be as correct as thought. The first section of this paper will briefly introduce the two main types of market structure. Perfect competition is a market that satisfies the conditions of having many buyers and sellers, firms selling identical products, having zero barriers to entry and having perfect information.
A perfectly competitive firm is a price taker as it has no power of affecting the market price. In reality, perfect competition is only a theoretical model and it does not really exist in real-world market (Makowski 2001, 480; Ziebarth 2008, 3 and Pettinger N. Y, sec. 2) although there are some markets that can get slightly close to the previously discussed characteristics such as markets for organic food and currency markets. Despite this, perfect competition is still used as a benchmark since it displays high level of economic efficiency (Riley 2006, sec. 11, par. 1).
With the second market structure, a firm is considered as a monopoly only when there is one seller providing certain goods or services with no close substitute and it can ignore other firms’ actions as it is a price maker. (Hubbard, Garnett, Lewis and O’Brien 2010, 224). In regards to the illustration of which industry leads to more efficient outcomes, the following discussion will consist two main parts which represent for the two ways economists use to evaluate perfect competition and monopoly. The first part relates to individual firms in terms of efficiency concept.
The second part involves the industries and the level of economic welfare contributed to the entire society. Taking the first part in account, the three concepts of efficiency are of great importance. There are three types of efficiency: allocative, technical and dynamic efficiency. With allocative efficiency, products are produced up to the point where price, or marginal benefit, equals marginal cost of producing an extra unit. Technical efficiency refers to the act of producing a level of outputs using the least amount of resources.
Dynamic efficiency is about the adoption of new technology over time to improve production techniques and meet the changing consumer demands (Lewis, Garnett, Treadgold and Hawtrey 2010, 94). Below are the two graphs showing firms’ efficiency in providing goods and services in long-run: Perfect competitionMonopoly The left graph shows the long-run equilibrium of firms in perfect competition. According to this diagram, firms actually earn a zero economic profit since they have to accept the price determined by the whole industry.
Thus, their MR curve is the same as their D curve which means they will produce at the output level Q where they can only cover the ATC. Thus, firms are seen as achieving both allocative and technical efficiency. They are allocatively efficient because they will produce up the point where price equals MC of producing an extra unit due to high level of competitors leaving and entering the market in short-run. Furthermore, the firms must minimize their production cost because of zero economic profit.
In other words, if they fail to produce at the lowest point on the ATC curve, they have to charge a higher price which basically means they will be driven out of business in such highly competitive markets. So, in this case, perfectly competitive firms can also obtain technical efficiency. As seen in the right graph, with the lack of competition, firms in monopoly can earn great economic profits since they charge a much higher price compared to perfectly competitive firms. According to the diagram, there is allocative inefficiency since monopoly price is higher than MC; firms are producing too little while offering a too high price.
In other words, with monopolists, “resources are under-allocated” to the production of their product (Layton, Robinson and Tucker 2009, 223). Along with this, monopoly firms are not producing the level of outputs where ATC is at its minimum point due to the assistance of high barriers to entry. Thus, firms in monopoly once again fail to gain technical efficiency. Considering the previous discussion, the next section of this paper will explore how the industries of perfect competition and monopoly affect consumer surplus and producer surplus and hence, economic welfare as a whole.
In brief, consumer surplus is the difference between the maximum price a consumer is willing to pay and the actual price paid. Producer surplus is the difference between the minimum price a firm is willing to charge and the actual price charged. Below are the two graphs illustrating the differences in economic welfare between the two market structures: Perfect competitionMonopoly Within perfect competition industry, the equilibrium point indicates both profit-maximizing price and profit-maximizing quantity since the firms within perfect competition industry are allocatively and technically efficient.
Thus, this results in maximum economic welfare which is the sum of consumer surplus and producer surplus as shown in the left diagram. With the right diagram, while Pc and Qc are price and quantity of perfect competition, Pm and Qm represent for price and quantity of monopoly. As seen in this diagram, monopoly charges higher price which makes price increase from Pc to Pm. Hence, this end up in a loss in consumer surplus which is area 1, this loss becomes the gain of monopoly.
Moreover, due to the decrease of output level from Qc to Qm, there is a loss in consumer surplus – area 2, and a loss in producer surplus – area 3 as well. So these two losses are actually added up together as a deadweight loss in economic welfare for society. In short, perfect competition leads to more efficient outcomes to society in terms of efficiency concept and economic welfare. A perfectly competitive firm is more allocatively and technically efficient and it also lead to maximum economic welfare. Besides this, monopoly leads to inefficiency and deadweight loss for society.
However, there are still some exceptions to this conclusion by which perfect competition may not be that efficient and monopoly may not be that inefficient. In relevance to the first exception, perfect competition is not as efficient as thought since it can end up with a market failure. One fundamental example of this would be one with externalities. An externality could be a benefit or cost that affects a third party of the exchange of the good. Two types of externalities are positive externality and negative externality; both deal with the extra benefit and cost to society that are not recognized by erfect competition industry. As a result, economic efficiency will be reduced and ended up as a deadweight loss as shown in the following diagrams: Positive externality Negative externality The second exception refers to natural monopoly by which monopoly can be considered productive efficient. According to McTaggart, Findlay and Parkin (2010, 222), a natural monopoly arises when one firm having large economies of scale can supply products to the entire market at a lower average total cost than several firms can. A prime example of this would be a power station.
In general, it is of more efficiency when having only one firm serving the market than many competitive firms. This is true because many firms operating in such markets may have to produce at a much higher average total cost and thus, offer higher price than the natural monopoly. And this certainly leads to more inefficient outcomes. The final exception deals with the probability of firms having innovations and this relates to the dynamic efficiency concept. With perfect competition, due to high level of competition, firms may want to better their production techniques in order to compete with others.
Yet in the long run, firms earn zero economic which also means that they do not have sufficient funds for R&D. It is once again argued here that non-competitive firms like monopoly make large profits which can be spent for R&D. Thus, monopoly in this case is more efficient in providing improvements and innovations to the products offered which is a significant benefit for society overall. In conclusion, the finding of this paper is that perfectly competitive firms achieve both allocative and technical efficiency while monopoly firms do not.
Also, perfect competition is more efficient when helping the society obtain the maximum economic welfare while monopoly ends up with a deadweight loss. On the other hand, this paper has also brought up externalities, natural monopoly and innovation as some exceptions where perfect competition is not efficient as thought and monopoly can be more efficient. But for most cases, perfect competition is still a preferred economic model due to its high level of efficient outcomes for society. REFERENCES: Hubbard, Glenn, Anne Garnett, Phil Lewis and Tony O’Brien. 2010.