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Pluralism in Economics: inequalities, innovation, environment
Pluralism in Economics: inequalities, innovation, environment

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3 Why competition is good according to neoclassical economics

The main neoclassical argument against market power relies on the extent to which it leads to higher prices for consumers, and to a loss of efficiency in production. The following activities will show you the basic argument by comparing the market equilibria of a perfectly competitive market to a market with one supplier only, the monopolist.

One of the most significant departures of the monopoly supply model, compared to the perfectly competitive supply model, is that the monopolist is not a price taker. The demand it faces is the market demand. It is therefore decreasing with respect to price: the firm must cut its price in order to attract more buyers and sell more. This has one additional implication for understanding the firm’s supply and pricing behaviour: because an additional unit of production changes the price charged on all units, price is no longer equal to marginal revenue. In fact, marginal revenue always lies below the market demand (average revenue) curve.

Activity 3: Comparing competition and monopoly models

Timing: 10 minutes

This activity compares the perfect competition and monopoly models. You will first be asked to watch a video.

The video also shows another cost curve, the average cost curve. It measures the total cost of production divided by total number of units produced.

Average costs initially decrease as production increases. This mainly reflects fixed costs – from items like buildings and managerial salaries, and the purchase cost of machinery - which don’t vary with the volume of production: When these fixed costs are spread across a greater volume of output, the average cost of a unit of output falls.

But as the expansion of output requires the firm to use more inputs, average costs begin to rise. The demand for more inputs pushes their costs up in the short term, and the costs of managing production tend to rise as it expands. These rising marginal costs pull the average costs up, though not as sharply.

A measure of efficiency used in the video requires both measures of cost, average and marginal. We say a firm is being productively efficient when its optimal supply lies where average costs are at their minimum. This must be the point where the marginal cost curve intersects the average cost curve and equals the market price. Let’s see why this is the case in the perfectly competitive model explained in the video

Task 1

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Transcript: Video 2: Efficiency - perfect competition vs. monopoly

INSTRUCTOR
Let’s look at the point of profit maximisation for a firm in perfect competition, compared to a monopolist. We will assume each firm has similar cost curves. We will assume the firm has a long run average cost curve like this, and a long run marginal cost curve like this.
First, let’s consider the case of perfect competition. A firm in a perfectly competitive market is a price taker. A price taker can only control the quantity they produce. The firm will maximise profit by producing an output where marginal revenue equals marginal cost. This is at quantity Q1.
In the long run, the entry and exit of firms removes the opportunity to make supernormal profits at this market equilibrium price, P1. Only those firms with the lowest cost can supply the market and only make normal profit.
Firms are producing at the lowest point of their long run average cost curve, so firms are productively efficient. They are not wasting resources. Firms are only making normal profit. In fact, at Q1, price equals marginal cost.
The market price also equals marginal utility. So marginal cost equals marginal utility. Producing at Q1, the firm’s resources are allocated efficiently, without waste. This means that consumer satisfaction gained from the last unit supplied is equal to the cost of producing that unit. The consumer would be worse off if output were to increase or decrease from Q1.
In the case of a monopoly firm, it has a downward sloping demand curve. The monopolist demand curve is the market demand curve. The price at which a monopolist can sell its products is inversely related to the quantity sold.
A monopolist’s marginal revenue curve is also downward sloping. It will profit maximise by producing at the point where marginal revenue equals marginal cost. This is at quantity Q1.
Price equals P1. Price is much greater than long run average cost, AC1. The firm is making supernormal profit.
Monopolist firms are not necessarily producing at their lowest point of their long run average cost curve, so some monopolists are not productively efficient. The monopolist is making supernormal profit producing at Q1. Price is greater than marginal cost. So it follows that marginal utility, which is equal to price, is greater than marginal cost.
If a monopolist is producing at Q1, the market could allocate resources more efficiently. The consumer were better off if the monopolist increased output to Q2, where marginal cost equals price, and marginal cost equals marginal utility. However, at Q2, the firm would be making less profit. As the firm is a monopolist, it would prefer to profit maximise and produce at Q1.
End transcript: Video 2: Efficiency - perfect competition vs. monopoly
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Video 2: Efficiency - perfect competition vs. monopoly
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Task 2

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Needless to say, and given the importance of neoclassical economics over time and across the globe in setting policy agendas, most regulatory intervention acts on price and efficiency.