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Profit Max, Perfect Competition,
Deadweight Losses
Two important pieces of information:
There is a typo at the top of page 117 in Chapter 5 in the section on horizontal addition of demand curves. It should read:
Chapter 6. Perfect Competition and The Cost Side of the Market Key points:
Elasticity of supply is defined just like elasticity of demand, except that it describes the relationship between price and quantity supplied. The percentage change in quantity supplied divided by the percentage change in the price. What would a perfectly inelastic supply curve look like? It would be vertical. What would a perfectly elastic supply curve look like? It would be horizontal. Firms maximize profits. Profits are the difference between revenues and costs. Quantity times Price equals Revenue. Quantity times Average Cost equals Costs. When we say costs we mean all costs--explicit and implicit. In a modern economy, the accounting principles for revenues and costs are quite complex, leaving a lot of scope for errors and for malfeasance. A perfectly competitive market is defined as a market in which no individual supplier has significant influence on the market price of the product. By definition, this means that an individual firm faces a perfectly horizontal demand curve. The price is fixed. Demand is infinitely elastic. In other words, an individual firm is so small that it cannot have any influence on the price. The demand curve for the INDUSTRY is still downward sloping. The intersection between demand and supply in the INDUSTRY determines the price facing the individual FIRM. What does the individual firm's supply curve look like? In the long run, it might be very elastic--almost horizontal, because the firm can make decisions to buy new factors of production, such as capital, land, equipment, labor, raw materials.... But in the short run, at least one of its factors of production is usually fixed--capital or land tend to be the fixed factors. It takes time to buy new machinery or land... If one factor is fixed, the law of diminishing returns comes into play. If you keep adding more workers, for instance, but keep the level of capital and the size of the factory fixed, output per worker will tend to fall. But pay each of the workers the same amount. So, the cost per unit of output will go up. This is a fancy way of saying that marginal costs go up, and that the supply curve facing the individual firm slopes up. The individual profit maximizing firm cannot choose its price. But it CAN choose its level of production, or quantity produced. It will choose the level at which the marginal revenue is equal to the marginal price. Since the price is constant, marginal price equals average price. Note that at the profit maximizing price, firms are not necessarily making profits. They are just doing the best they can, under the circumstances. We will come back to this in Chapter 8. Competition tends to lower profits--often to zero. Look around this area that you're living it. It used to be full of small farms. In the eighteenth and early 19th century much of the land was cleared. Grain and cattle were raised, shipped down river to Springfield and carried overland to Boston. But grain and cattle can be raised more efficiently in the Midwest (comparative advantage!). Once railroads were built, transporting those cheaply to markets on East coast, price competition drove most New England farmers out of business. Some of them moved into truck farming--onions and cucumbers. This was viable for a longer period of time, because this produce had to reach market quickly before spoiling...but advent of refrigeration drove this out...(though there are still some remnants in Hadley). Then manufacturing sprang up--the rivers of New England provided a comparative advantage for the energy required to power factories....textile mills sprang up, then machine tools.... But the development of centralized electricity generation diminished the advantage of water power, and wages were cheaper elsewhere. In the period after World War II, New England experienced "de-industralization" as most manufacturing moved either to the South or overseas. Look at the labels on your clothes and sneakers. It's unusual to find any that are made in the U.S.A. "Globalization" is an aspect of this process. The increased importance of foreign trade and also the export of U.S. manufacturing facilities overseas, literally "capital mobility"--the capital invested in plant and equipment becoming more mobile and going in search of lower cost inputs--especially cheaper labor. Consumers benefit from this increased competition because it tends to lower prices--prices of clothes, shoes, electronic goods, many manufactured goods. But it drives many U.S. manufacturing firms out of business... So, we are now becoming a "service" economy. But what about increased international competition in services? If you want to pursue this issue further, there's more discussion of it in The Invisible Heart. See the chapter called "CorporNation." Chapter 7. The domain of markets. Competitive markets create some positive incentives--to innovation and to cost-cutting. They also create some negative incentives--e.g. to deception and cheating. Analogy: a race in which individuals who use steroids or other drugs enjoy an advantage. If you don't figure out a way to test for drugs and punish drug use, you create a situation in which competitors who don't use drugs are at a disadvantage. Many aspects of regulation perform an analogous role. Are the positive incentives greater than the negative ones? Most people think so. It depends who you are and what year it is.... Competitive markets do seem to have some advantages in terms of incentives to efficiency, if you take the existing distribution of property and resources as a given, and prohibit any consideration of redistribution. Pareto efficiency: if you can't make anybody better off without making someone else worse off (even by a teeny bit). The concepts of consumer surplus and producer surplus provide a good reminder of how supply and demand curves work and also help illustrate the benefits of market forces. See Figure 7.7. Taxes reduce the "economic surplus." See Figure 7.19 for a picture of the effect of a per unit tax. The tax raises revenue for society as a whole. So the overall effects depend on how that tax money is spent! However, there is also a "deadweight loss" which is a reduction in surplus that is greater than the amount of revenue raised by a tax. See Figure 7.22. The deadweight loss is smaller if demand and supply are relatively inelastic. In general, if you're going to tax something, it's best to tax something that is relatively inelastic. A tax on cigarettes or alcohol changes individual behavior less than a tax on food or housing. Even better is to tax something that has negative consequences for personal or environmental health...because by raising the price, you discourage consumption of that good....
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