"Discuss and evaluate the proposition that perfect competition is a more efficient market structure than monopoly."

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“Discuss and evaluate the proposition that perfect competition is a more efficient market structure than monopoly.”

Adam Smith said that competitive forces function like an “invisible hand” to ensure that people pursuing individual interests simultaneously serve interest of society. Competition among economic agents would therefore narrow selfish interest of each person in a sociable desirable direction. Therefore perfect competition would lead allocative or economic efficiency. On the other hand monopolies could lead to lower cost due to economies of scale. Although in the real world it is very difficult (almost impossible) to have a pure perfect competition or monopoly, both of them, in theory, bring benefits to society. In order to evaluate whether perfect competition is a more efficient market structure than monopoly, there has to be a direct comparison between the two market structures to draw conclusions.  

In theory, the existence of positive economic profits in any given industry attracts new firms, therefore the supply increases and the price lowers to the point where normal returns are earned by the representative firm. Perfect competition is a market model. It has various characteristics. The market contains a large number of buyers and sellers. Each buyer and sellers has a perfect knowledge about prices and product. The product being sold is homogeneous; this means that it is not possible to distinguish the product of one firm from that of other firms. There are no barriers to entry into or out of the industry; this means that there is a freedom of entry and exit. All firms are price takers; no single seller has control over the price.

Industry Demand in Perfect Competition                Firm Demand in Perfect Competition

The industry demand in perfect competition is a common demand curve, the demand decreases as price increases (Diagram 1). There are many sellers within the market; therefore the effect of one of them would be insignificant. The firms in a perfect competition environment are said to be price takers. The demand curve of a perfectly competitive firm is perfectly elastic at the going market price like diagram 2 shows. This means that the seller can sell all their products at the market price without affecting this price.

The theory of perfect competition also is based on the assumption that firms seek to maximize profits. Economic profits indicate whether or not resources are being directed to their best use. They represent the amount by which revenue exceed total opportunity costs. For example, Santiago has a motorcycle business. Santiago has placed $60.000 of his money into his own business. However, he could earn $2000 per month working as a motorcycle seller at another motorcycle shop. Moreover, Santiago’s capital investment in his own business might earn $500 monthly elsewhere. The sum of this two ($2500) is an implicit cost of doing the business. The explicit or accounting costs involve are Santiago’s rent payments on the building, inventory costs, business taxes and wage payments to mechanics and sellers. All of these add up to $37000 per month. Santiago’s total monthly opportunity cost for operating his business is the sum of implicit cost ($2500) and explicit costs ($37000) = $39500. Supposing that Santiago’s business has monthly sale of $40000, Santiago’s accounting profit would be $3000 per month. Santiago’s economic profit is only of $500 because the total opportunity costs are $39500. If in this case the accounting profit was below $2500, Santiago would not have entered the business because he would not earn a normal profit.

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In order to maximize profits marginal cost (MC) must equal marginal revenue (MR). A firm will always produce a t the point when P=MC. The diagram below shows the short term equilibrium of a firm and the market in a perfect competitive market.

The Representative firm                                                       The market

As long as the ATC curve is underneath the price line (P) there would be an economic ...

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