Economics. Perfect Competition, Price Controls and Market Structure
Economics. Perfect Competition, Price Controls and Market Structure ECON 201
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This 6 page Class Notes was uploaded by Clarissa Salinas-Arrieta on Wednesday October 5, 2016. The Class Notes belongs to ECON 201 at New Mexico State University taught by Christopher Osuoha in Fall 2016. Since its upload, it has received 21 views. For similar materials see Economics in Economics, Applied Statistics and International Business at New Mexico State University.
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Date Created: 10/05/16
Perfect Competition, Price Controls & Market Structure Chapter 4, 7 and 8 Key Terms Important Consumer Surplus and the Demand Curve In this document the concepts of consumer and producer surplus are going to be used to understand how buyers and sellers benefit form a competitive market and how big those benefits are. These concepts also play an important role in analyzing what happens when a competitive markets don’t work well or there is interference in the market. A consumer’s willingness to pay for a good is the maximum price at which the individual would purchase that good. For example: You find a used cellphone for 100 dollars, however, if your willingness to pay is 70 dollars you are not going to buy it. The accumulative gain that a purchaser achieves from buying a good is called that buyer’s individual consumer surplus. It is equal to the difference between the buyer’s willingness to pay and the price paid. For example: You have a willingness to pay only 70 dollars for a used cellphone and you find the cellphone you are looking for only 60 dollars. Your individual consumer surplus will be 10 dollars (70- 60=10). However, knowing an individual’s surplus isn’t good enough. Total consumer surplus is the sum of the individual consumer surpluses of all the buyers of a good in a market. This concept can be represented graphically, however this demand curve is stepped, with alternating horizontal and vertical segments. The total consumer surplus generated by purchases of a good at a given price is equal to the area below the demand curve but above that price. The concept consumer surplus is often used to refer to both individual and consumer surplus. How Changing Prices Affect Consumer Surplus A fall in the price of a good increases consumer surplus through two channels: 1. A gain to consumers who would have bought at the original price and 2. A gain to consumers who are persuaded to buy by the lower price. Producer Surplus and the Supply Curve Producer Surplus and the Supply Curve Cost is defined as the lowest price at which a potential seller is willing to sell (The real cost of something is what you must give up to get it). In most real-world markets the sellers are also those who produce the good and therefore do spend money to make the good available for sale. In this case the cost of making the good available for sale includes monetary costs, but it may also include other opportunities cost. Individual producer surplus is really alike to individual consumer surplus so you must not confuse them. Individual producer surplus is the accumulative gain to an individual seller from selling a good. This is equal to the difference between the price received and the seller’s cost. Total producer surplus in a market is the sum of the individual producer surpluses of all the sellers of a good in a market. The total producer surplus from sales of a good at a given price is the area above the supply curve but below that price. Total Surplus The total surplus generated in a market is a total net gain to consumers and producers from trading in the market. It is the sum of the consumer and the producer surplus. The idea of consumer surplus and producer surplus can help comprehend why markets are an effective way to organize economic activity. Consumer Surplus + Producer Surplus + Gains from Trade = Gains of trade Both consumers and producers are better off because there is a market for this good, i.e., there are gains from trade. Why Governments Control Prices The market price moves to the level at which the quantity supplied equals the quantity demanded. But this equilibrium price does not necessarily please either buyers or sellers. Buyers always like to pay less if they could and sellers on the other hand would always like to get more money for what they sell. Both can make a strong moral or political case that they should pay lower prices (buyers) or they should receive higher prices (sellers). Price controls are legal restrictions on how high or low market price may go. They can take two forms: a price ceiling, a maximum price sellers are allowed to charge for a good or service, or a price floor, a minimum price buyers are required to pay for a good service. Price Ceilings Price ceilings are typically imposed during crises. For example: natural disaster, wars, and/or harvest failures. Mainly because these events often lead to unexpected price increases that it may hurt many people but produce big gains for some. However, price ceilings lead to inefficiency. Among a lot of things that price ceilings can do, it can give rise to illegal behavior as people try to deceive them (Black market). Some other outcomes of price ceiling: o Inefficiently Low Quantity o Inefficient Allocation to Consumers: People who want the good badly and are willing to pay a high price don’t get it, and those who care relatively little about the good and are only willing to pay a low price do get it. o Wasted resources: People expend money, effort, and time to cope with the shortages caused by the price ceiling. o Inefficiently Low Quality: Sellers offer low-quality goods at a low price. An inefficiently low quantity is lower than the quantity in an unregulated market. It creates a deadweight loss. Deadweight loss is the loss in total surplus that occurs whenever an action or a policy reduces the quantity transacted below the efficient market equilibrium. In a graph it is a triangular area that represents the overall loss to society and is sometimes called deadweight- loss triangle. Dead loss is a key concept in economics, one that will encounter whenever an action or a policy leads to a reduction in the quantity transacted below the efficient market equilibrium quantity. Even though price ceilings are sometimes can cause catastrophic shortages and illegal activity, they do have a benefit. o Price ceilings can give a small minority of renters much cheaper housing than they would get in an unregulated market. o When price ceilings have been in effect for a while, buyers may not have a reasonable idea of what would happen if they didn’t existed. o Is quite normal that Government not understand supply and demand analysis. Price ceilings are often imposed because they benefit some influential buyers of a good. Price Floors Sometimes governments intervene to push market prices up instead of down. The minimum wage is a legal floor on the wage rate, which is the market price labor. And just like price ceilings, price floors sometimes are intended to help people, however both can result on undesirable and sometimes predictable side effects. o The persistent surplus that results from a price floor creates missed opportunities— inefficiencies—similar to those created by a price ceiling. o These include: Deadweight loss from inefficiently low quantity Inefficient allocation of sales among sellers Wasted resources Inefficiently high quality offered by sellers Temptation to break the law by selling below the legal price So why do government impose price floors when they have so many negative side effects? Mainly because price floor benefit some influential sellers. Controlling Quantities A quantity control, or quota, is an upper limit on the quantity of some good that can be purchased or sold. Quota limit is the total amount of the good that can be legally transacted. Typically, a government limits quantity in a market by issuing licenses, which gives its owner the right to supply a good. The Anatomy of Quantity Controls A quantity control, or quota, drives a wedge between the demand price and the supply price of a good; that is, the price paid by buyers ends up being higher than that received by sellers. Quota rent is the difference of demand and supply price at the quota limit. The earnings that accrue to the license-holder from ownership of the right to sell the good. It’s equal to the market price of the license when the licenses are traded. Perfect Competition and Price-Takers A price-taking producer is one whose actions have no outcome on the market price of the good or service it sells. A price-taking consumer is one whose actions have no effect on the market price of the good or service the individual buys. A perfectly competitive market is a market in which all participants are price-takers. A perfectly competitive industry is an industry in which all producers are price-takers. Two Necessary Conditions for Perfect Competition 1. For an industry to be perfectly competitive, it must contain many producers, none whom have a large market share. A producer’s market share is the fraction of the total industry output accounted for by that producer’s output. 2. An industry can be perfectly competitive only if consumers regard the products of all producers as equivalent. A good is a standardized product, also known as a commodity, when consumers regard the products of different producers as the same good. Free Entry and Exit An industry has free entry and exit when new producers can easily enter or leave that industry. Free entry and exit ensure that: o The producers in an industry can adjust to changing market conditions. o Producers cannot act to keep other firms out. Types of Market Structure In order to develop principles and make predictions about markets and how producers will behave in them, economist have developed four principal models of market structure: perfect competition, monopoly, oligopoly, and monopolistic competition. This system of markets structures is based on two dimensions: 1. The number of producers in the market (one few many) 2. Whether the goods offered are identical or differentiated o Differentiated goods are goods that are different but considered somewhat substitutable by consumers (think Coke vs. Pepsi). Monopoly A monopolist is a firm that is the only producer of a good that has no close substitutes. A monopoly is an industry controlled by a monopolist. Market power is the ability of a monopolist to raise its price above the competitive level by reducing output. The reason a monopolist reduces output and raises price compared to the perfectly competitive industry levels is to increase profit. Why Do Monopolies Exist? A monopolist has market power, which results in higher prices and less output than under perfect competition. A monopolist earns both short-run and long-run profit. Profits persist in the long run because of a barrier to entry (something that prevents firms from entering industry), in the form of: o Control of natural resources or input o Increasing returns to scale o Technological superiority o Network externality o Government-created barriers (patents and copyrights) A natural monopoly exists when increasing returns to scale provide a large cost advantage to a single firm that produces all of an industry’s output. Oligopoly Oligopoly is an industry with only a small number of producers. A producer in such an industry is an oligopolist. When no one firm has a monopoly, but producers nonetheless realize that they can affect market prices, that industry is characterized by imperfect competition. The two companies may engage in collusion: when they cooperate to raise each other’s profits. The strongest form of collusion is a cartel, an agreement to restrict output to increase joint profits. However, each firm has an incentive to cheat. They may also engage in noncooperative behavior, ignoring the effects of their actions on joint profits. The Meaning of Monopolistic Competition Monopolistic competition is a market structure in which: o There are many competing producers in an industry o There is free entry and exit from the industry in the long run o Each producer sells a differentiated product o Differentiated products play a crucial role in monopolistically competitive industries.
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