Friday, October 23, 2009

Econ 101: Perfect Competition, Part 3

Oops...took longer than I had planned to get back to this, sorry.

In my previous two posts on perfect competition I covered the basics of the assumptions (market structure), the supply and demand side (market conduct) and the notion of equilibrium.

Today I am going to talk about why markets are so great.

If we look at the above illustration of market equilibrium for some good there is one aspect that immediately stands out: all the consumers that had a reservation price for the good that was above or equal to the market equilibrium price were able to purchase the good. Similarly, all of the suppliers who were able to supply the good for a cost below or at the market equilibrium price were able to sell their goods. The is one aspect of the efficiency of markets - all of the buyers and sellers who should transact, do. So there is no benefit to either party that is left 'on the table' by the market - all of the possible benefits are enjoyed by the participants in the market.

And notice the next aspect: every single one of these transactions was entered into willingly because they left both buyers and sellers better off. Let's return to the example of the yard sale. Many people have around their houses stuff that they no longer want and can supply it to a market (in this case the market that they created in their front yard) at very low cost. The potential customers are the ones who have some value for the stuff. That people are able to sell stuff from their front yard is a good thing because these buyers and sellers can come together for mutually beneficial exchanges. Society benefits then from having free markets so that such exchanges can happen and everyone can benefit.

There is another aspect of the efficiency of free markets that I will just mention in passing. Since free markets are, by definition, ones that anyone can enter, this causes competitive pressure on the part of firms. Notice that if someone invents a technology or process that can save just a tiny bit of cost, they could reap huge benefits by being able to undercut other firms' prices. This then creates relentless pressure to be efficient on the part of firms and ensures that no firm is wasteful in the sense that they are needlessly costly in their production of any good.

So there you have it - the wonder of free markets. Contrasting this with markets in which there is not free entry shows that less than optimal amounts of the good will be sold and that the firms may not be efficient - both of which lead to lower benefit to society.


To complete the analysis, let's go back to the implicit assumptions that we started with (the implications of the explicit assumptions I think are more or less self-evident).

In order for these results to hold we have to have full and complete information: most importantly, all consumers must know all about the product (so they can value it properly) and all of the prices that it is being offered at (so they can always go for the lowest). [NB: we can alter the model easily to deal with real world realities like transportation costs, to wit, you would usually go to the store down the block than across town just to save a penny]

There also can be no external costs and benefits. The easy way to see this is with external costs. The supply curve is based on private costs and we get efficiency from the fact that all suppliers with costs below the price supply. But what if, in the production of the good, the supplier gives off toxic smoke that is damaging to local residents' health? Well then the true social cost of the good is higher than the private good and there will be exchange of good that should NOT be exchanged: people who value them for more than the private costs but less than the total costs will buy and consume them when they should not (from a social welfare perspective). These exchanges start diminishing the total surplus from the market and efficiency is lost.

This is precisely the rationale for a carbon tax, by the way. By making the cost of carbon emissions part of the private cost of production, market efficiency is restored.

One last note, these have to be private goods, only those that purchase the good can consume it, so these markets do not work well for things like city parks, streets etc.

So that is the essence of perfect competition and free markets and why economists often extoll the virtues of them. Any good economist will, in the same breath, acknowledge the assumptions and the potential for market failure as well, however. That said, most of us start with the idea that a market solution is the best in most cases and only if it is clear that market failures are significant and that a regulatory solution is available that can correct the failure at a reasonable cost (not more than the cost of the failure itself) should markets be constrained. We do this not out of some fetish for profits, competition and greed, but because we understand that everyone benefits from free markets.

Think of our yard sale example. What if the government outlawed them entirely or put onerous restrictions on them? Lots of people would loose out on the opportunity to engage in mutually beneficial exchange. The poor college student who needs a cheap couch no matter how tattered and the family who have finally replaced their old couch with a new one both benefit from finding each other and transferring the couch. This is what markets are all about.

And, by the way, this is why markets and market-based economies arise naturally and this is also why acting in your own self interest is good for all. The poor college student does not care about the family who bought a new couch and the new family is not acting out of a sense of concern for the college student, but they are helping each other nonetheless.

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