Monday, June 27, 2011

What is Perfect Competition?


In competitive markets there are:
  1. Many buyers and sellers - individual firms have little effect on the price.
  2. Goods offered are very similar - demand is very elastic for individual firms.
  3. Firms can freely enter or exit the industry - no substantial barriers to entry.
Competitive firms have no market power. Recall that businesses are trying to maximize profits, and Profit = Total Revenue (TR) - Total Cost (TC).

Principle of Economics #7: Governments can sometimes improve market outcomes. Markets do many things well. With competition and no externalities, markets will allocate resources so as to maximize the surplus available. However, if these conditions are not met, markets may fail to achieve the optimal outcome. This is also known as "market failure".

If a big business is involved in activities that, say pollutes water, then it is harming fellow citizens and it's own consumers. This is called a 'negative externality'. This is an example of perfect competition NOT working efficiently. In such situations the government steps in a balances the situation so immoral business practices creating negative externalities can be controlled creating a better community and business atmosphere for everyone. That is why in practice (i.e. in the Real World) perfect competition with no regulation rarely exists, instead we have 'mixed economies' which is what exists in all democracies (and helps a democracy function better if the laws are set and administered appropriately)

More about Perfect Competition from Investopedia:

What Does Perfect Competition Mean?
A market structure in which the following five criteria are met:

1. All firms sell an identical product.
2. All firms are price takers.
3. All firms have a relatively small market share.
4. Buyers know the nature of the product being sold and the prices
charged by each firm.
5. The industry is characterized by freedom of entry and exit.

Investopedia explains Perfect Competition
Perfect competition is a theoretical market structure. It is primarily used as a benchmark against which other market structures are compared. The industry that best reflects perfect competition in real life is the agricultural industry.

What is a Market Economy?

Adam Smith popularized the idea of the 'invisible hand' that guides market forces. The idea is that the demand of individual and groups of consumers when matched with the supply of the goods that are demanded will create a fixed price which will distribute all the goods (supply) to all the consumers who can afford it (demand).

Adam Smith did say that government intervention may be needed to balance the market forces. i.e. a large business can force out a small business, or find a way to cheat or scam consumers etc. (will be explaining this more in 'perfect competition' next)

The following are some extracts to help explain what a market economy is, then I will be getting into some of the basics of economics...

From Investopedia:

What Does Market Economy Mean?

An economic system in which economic decisions and the pricing of goods and services are guided solely by the aggregate interactions of a country's citizens and businesses and there is little government intervention or central planning. This is the opposite of a centrally planned economy, in which government decisions drive most aspects of a country's economic activity.

Investopedia explains Market Economy

Market economies work on the assumption that market forces, such as supply and demand, are the best determinants of what is right for a nation's well-being. These economies rarely engage in government interventions such as price fixing, license quotas and industry subsidizations.

While most developed nations today could be classified as having mixed economies, they are often said to have market economies because they allow market forces to drive most of their activities, typically engaging in government intervention only to the extent that it is needed to provide stability. Although the market economy is clearly the system of choice in today's global marketplace, there is significant debate regarding the amount of government intervention considered optimal for efficient economic operations.

Since the government will always have some level of regulatory control, no country operates as a free market in the strict sense of the word, but we generally say that market economies are those in which governments attempt to intervene as little as possible, while mixed economies include elements of both capitalism and socialism.

Note above that in a centrally planned economy EVERYTHING is planned by the government, i.e. how many crops are to be produced, which crops are to be produced, who get how much of the crop and in what proportion. This means that if you don't want something (ex. rice) and want something else instead (ex. bread) you have no choice in the matter as the government has made that decision for you.

Also note that in a free market economy subsidies are unheard of as subsidies are meant to either protect a producer of goods or promote the development of an industry. In a free market economy the kind of oil subsidies that exist in the States would not exist.

Sunday, June 26, 2011

How Demand and Supply Works.

The following are a few extracts from an excellent article that explains how demand and supply works. Note: Demand is the desire to buy something (by an individual or group) and supply refers to the availability of that something. Economists use graphs to analyse changes in demand and supply and as a means to determine price and how variable its price may be based on the types of demand and supply situations being faced by an economy.

All the following extracts are from investopedia's article on demand and supply (please read the original article with it's graphs carefully as they will be used to explain economics in future posts);

A. The Law of Demand
The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more.

B. The Law of Supply Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.

Time and Supply
Unlike the demand relationship, however, the supply relationship is a factor of time. Time is important to supply because suppliers must, but cannot always, react quickly to a change in demand or price. So it is important to try and determine whether a price change that is caused by demand will be temporary or permanent.

Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy season; suppliers may simply accommodate demand by using their production equipment more intensively. If, however, there is a climate change, and the population will need umbrellas year-round, the change in demand and price will be expected to be  long term; suppliers will have to change their equipment and production facilities in order to meet the long-term levels of demand.

C. Supply and Demand Relationship Now that we know the laws of supply and demand, let's turn to an example to show how supply and demand affect price.

Imagine that a special edition CD of your favorite band is released for $20. Because the record company's previous analysis showed that consumers will not demand CDs at a price higher than $20, only ten CDs were released because the opportunity cost is too high for suppliers to produce more. If, however, the ten CDs are demanded by 20 people, the price will subsequently rise because, according to the demand relationship, as demand increases, so does the price. Consequently, the rise in price should prompt more CDs to be supplied as the supply relationship shows that the higher the price, the higher the quantity supplied.

Saturday, June 18, 2011

Definition of Economics

Definition of ECONOMICS

a : a social science concerned chiefly with description and analysis of the production, distribution, and consumption of goods and servicesb : economic theory, principles, or practices <soundeconomics>
: economic aspect or significance <the economics of building a new stadium>
: economic conditions <current economics>

From Encyclopedia Britannica

"economics, Social science that analyzes and describes the consequences of choices made concerning scarce productive resources.

Economics is the study of how individuals and societies choose to employ those resources: what goods and services will be produced, how they will be produced, and how they will be distributed among the members of society."