Perfect Competition: Efficient Market
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A perfect or efficient market is a competitive market in which economic forces operate unimpeded. For a market to be perfect, the following conditions must exist:
a. There are numerous buyers and sellers. The output of the goods from each firm is small compared to the total supply of those goods so none of them are able to influence the price of the goods on their own.
b. There are no barriers to the entry of new competitions and competitors. Barriers can be legal, such as in patents and regulations; technological, such as with technologies that are too costly or available only to certain industries; or social, such as when loans or grants are available to only certain groups of people and not others.
c. There are many other firms with products that are available and practically indistinguishable from the goods of interest. Buyers could easily substitute another product if there were shortages.
d. A firm’s only goal is to maximize its profits; in other words, firms have no interests (political, social, etc.) other than their economical interest.
e. All consumers and producers face the same price; alternatively, information about prices is freely available so that buyers and sellers are price takers.
In actuality, markets are not perfect and many technical, financial, and legal barriers can influence them. In a real market there are only a limited number of buyers and sellers, so it is possible that a few firms collude to dominate the industry. Because the number of buyers is finite, there is a limit to how much of a product firms can sell, no matter how low the price. Monopolies, cartels, and subsidized firms that provide specialized services, sell novelty items, or offer products protected by patents and government regulations violate one or more of the conditions set above and are therefore not considered to be perfect or efficient markets.
It should be noted that although most barriers to a perfect market (control of resources, predatory and retaliatory pricing, and excess capacity) are socially harmful, there are some advantages for a non-perfect market. For example, the economics of scale may reduce capital requirements and reduce costs to the consumers. To a certain degree patents and copy rights will foster entrepreneurship and promote innovation. Finally, non-perfect markets allow product differentiation which brings variety that spices up our daily lives.
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Supply and Demand
To understand the many ramifications of modern economics, it is instructive to start with the concept of supply and demand and to explain how it determines an efficient price and quantity of a given good sold in a competitive market. In general, the theory claims that the quantity demanded for products increases as prices fall, ceteris paribus (a). At the same time, sellers will be willing to offer more goods at higher prices. It is therefore reasonable to expect a demand curve to exhibit a downward slope, (b) whereas a supply curve has an upward trend as the quantity of goods offered increases. The point where these curves intersect is the equilibrium point (Figure 1). At the equilibrium point, both buyers and sellers are satisfied with the transaction and therefore there is little impetus to change. In other words, at the equilibrium, everybody is better off from the trade (c). If the price is set too high or if supply increases, then there will not be sufficient buyers, resulting in a surplus. In this instance, suppliers will attempt to reduce their inventories by cutting prices, and producers, seeing the lower price, will cut production. As price falls more customers are likely to enter the market and the price and volume will increase, approaching the equilibrium.
If the price is set too low or if demand increases, then quantity demanded exceeds the quantity supplied, resulting in a shortage. In this case buyers are willing to pay more (and possibly develop a black market). Seeing prices rise, more sellers enter the market, suppliers increase their production, and again we approach equilibrium.
Many factors besides price affect demand and supply. Factors that affect demand are changes in income, changes in the cost of living, personal preferences, and customers’ expectations. Factors that affect supply are changes in the costs of production (such as the cost of raw materials and labor), changes in technology, and changes in the amount of taxes and subsidies.
It should be emphasized here that change in a quantity demanded does not mean a change in demand. There are two ways that demand can change: a change in price or a change in overall demand. For a given market, a change in the price results in changes in quantity demanded (movement along the demand curve); the higher the price, the lower the demand, and vice versa. For example, when the price of natural gas rises, buyers move away from natural gas and use substitutes such as heating oil, kerosene, or wood. When price drops, consumers switch back to natural gas again.
Demand can also change because of changes in market conditions. For example, when there is a shift in median income, people tend to buy a different quantity of a product for the same price. Since a demand curve represents the quantity demanded at different prices, a change in demand requires a shift in the demand curve. For example the demand for natural gas heaters increases during a cold winter. Unless supplies change, buyers are willing to pay a higher price than they would be during a mild winter, so the demand curve shifts upward and prices rise (Figure 2). The opposite will be true when winters turn out to be milder than expected. Supply curves can also change depending on cost. For example, as technologies improve, the cost of production of solar cells decreases, so cell manufacturers are willing to supply more cells for a given price -- the supply curve shifts to the right (Figure 3).
Example: Depending on their incomes and needs, different customers are willing to pay different prices for gasoline. Gasoline availability is also a function of the price customers are willing to pay, as it is shown in the supply curve denoted S0.
a. What is the equilibrium price of gasoline and the quantity supplied to the market?
b. If everything else remains the same (ceteris paribus), how would customers’ behavior be affected if the price of gasoline drops 10 cents to $3.90 a gallon?
c. How much would the price of gasoline rise during summer if demand rose by 20%? Assume that the government does not interfere in controlling supply and demand.
d. Now assume that the government mandates a price freeze setting a price ceiling of $4.00 per gallon. How would customers react to the change in demand during the summer?
e. How will the market react if it anticipates future shortages as a result of a 20% cutback in production by OPEC?
Solution:
a. The market equilibrium is at point A in graph a, where 100 million gallons of gasoline are supplied by the oil companies at a price of $4.00 a gallon.
b. In this case, the demand curve is not affected. This does not mean the quantity demanded is the same. In fact as gasoline prices drop the quantity demanded will be greater (people tend to drive more or buy bigger cars), although the demand is still the same. The movement is along the demand curve to point B and 110 million gallons are sold.
c. As daily demand for gasoline climbs, the demand curve shifts to D1, and customers are willing to buy 120 million gallons at the price of $4.00 (point C in graph b). In the short run, the market reacts and eliminates the initial shortage by driving prices up to point E at which 120 million gallons are sold at $4.20 a gallon. In the long run, as prices rise, drivers will cut their driving (for example by vacationing shorter distances or by carpooling) and equilibrium moves back to point D. As a result, 110 million gallons are offered at the price of $4.10 a gallon.
d. With the price ceiling set at $4.00 a gallon, the oil companies are willing to sell only 100 million gallons of gasoline every day (equilibrium point A in graph c). The daily demand for gasoline, however, is 120 million gallons. To prevent shortage, customers are willing to pay more, potentially causing a black market and driving up the prices to as much as $4.20 a gallon (point E). Because there is a price ceiling, drivers cannot legally pay more than $4.00 a gallon. In the absence of a black market, they have to pay in non-monetary terms such as waiting in line. In a way, a new equilibrium is reached where 100 million gallons of gasoline are traded at $4.20, of which $4.00 is paid monetarily and $0.20 is paid in terms of waiting in line.
e. In this case the supply curve shifts to S1 (graph c) while demand remains the same, and again we will face a daily shortage of 20 million gallons (AF), temporarily driving the price up to $4.20 a gallon (point E). In the long run, changes in consumers driving habits and willingness to switch to alternative fuel vehicles and to electric and hybrid cars reduce the demand for gasoline. It eventually reaches a new equilibrium point G where price drops to $4.10 again.
It is clear from the above example that the market has a built-in mechanism that reacts to scarcity by raising prices and ultimately eliminating scarcity. The rise in price causes a decrease in the quantity demanded, and an increase in the quantity supplied by providing incentives to existing firms to up production, to invest in new technologies, and to enable new firms to enter the market.
Total and Marginal Costs
There are many kinds of costs associated with activities, but they can be generally divided into two types -- fixed and variable. Fixed costs exist whether or not any products are produced or services are delivered. Examples are rent, furniture, insurance, and the cost of purchasing equipment. Other costs -- called variable costs -- change as output changes. Examples are the costs of raw material and labor. The sum of the fixed and variable costs is the total private cost, or simply the total cost.
All of these costs are important to a supplier, but they are not the most important costs for the firm to decide the quantity of goods to produce. That decision depends on whether the cost of producing one additional unit pays for the revenue received for that additional unit. The additional or incremental cost of producing one extra unit of product or providing one unit of additional service is called the marginal cost. The marginal cost of oil production is the minimal additional cost of producing one extra barrel of oil. Because higher production levels necessitate extraction from higher-cost fields, marginal cost increases as production rises. Similarly the marginal revenue (marginal benefit) can be defined as the additional or incremental revenue (benefit) of obtaining one extra product or receiving one unit of additional service (d). As long as the marginal benefit is higher than marginal cost, production of additional units is profitable. Said another way, the total profit of the firm is maximum when marginal cost of one additional unit produced is equal to marginal revenue resulting from its sale (the price it gets for its good).
Example: An agricultural firm is selling corn in a competitive market. The firm incurs a fixed cost of $20 (let’s say for rent) and an additional cost which depends on the quantity of corn produced. The data is given in columns 2 and 3 in the table shown. Assuming that the market price offered by the competition is $14 a bushel, find the number of bushels that the firm must produce to maximize its total profit.
Solution: We can calculate the total cost (column 4) by summing up values of fixed and variable costs (TC = FC + VC). Marginal cost (column 5) is calculated by taking the difference between the total costs of production where one additional bushel of corn is produced. Total revenue (column 6) is simply the product of the quantity produced and the unit price of $14. Total (column 8) and marginal (column 9) profits are calculated as the difference between total and marginal revenues and cost. (TP = TR - TC and MP = MR - MC).
As the results show, the total maximum profit the firm can make is $54.88 by selling 8 or 9 bushels of corn. This is where marginal cost and marginal revenue cross and are equal to the price of one bushel of corn ($14). The firm continues to be profitable as production increases beyond 9 bushels, although marginal profit starts to drop. Beyond 12 units of production the firm loses money at an accelerated rate.
It should be noted that the analysis made above is valid only in the short run. In a perfect competition, as long as there are profits to be made, there is incentive for other firms to enter the market. As new competitors enter the market, supplies increase and prices fall. Those who experience a loss will necessarily exit the market and are replaced with new firms that enter to fill the gap. The process continues until the equilibrium is reached (P = MR = MC), at which point the firms make no profit. This is the long-run condition for perfectly competitive firms.
Elasticity
Marginal quantities are closely related to the elasticity of demand and supply. Elasticity of supply can be viewed as the responsiveness of the market to changes in quantity supplied as prices change. The higher the number of substitutes for a given service or product, the more elastic the supply curve. When there is an infinite number of alternative products available in response to a change in price, we call the supply curve perfectly elastic (horizontal line in Figure 4). When there can be no change to quantity supplied, no matter the price, the supply curve is perfectly inelastic (vertical line in Figure 4). During a very short time, when a new product enters a market or when plant operates at full capacity, supply cannot change with a change in price; i.e the supply curve is highly inelastic. As new suppliers enter the market, the supply curve becomes more and more elastic. For a constant cost industry (such as an industry that uses inputs common to many other industries), the output is too small to affect prices of the inputs, and long run supply is perfectly elastic.
Similarly, elasticity of demand is a measure of the responsiveness of demand as prices change, i.e. the percentage change in sales caused by a percentage change in price. Demand is less elastic in the short run (there is less that we can do to moderate consumption), and more elastic in the long run (we can develop substitutes, learn to live without).
Externalities
When two people trade, the belief is that they both mutually benefit from that trade. Unless they are required by law, buyers and sellers are unlikely to consider the effect of their trades on others. Many trades and agreements have some direct and indirect effects whose costs are not borne by the buyers and sellers, and therefore prices do not reflect true costs. These costs are called external costs or externalities and include such things as the cost of health care associated with pollution and damage done to the environment, buildings, etc. Society at large must bear both the private cost of production as well as the externalities distributed among various sectors. The sum of private and external costs is called the social cost. Depending on whether the externalities benefit or harm the society as a whole, they can be positive or negative. Pollution is a negative externality, whereas cleaning the environment and research to eliminate an infectious disease are positive externalities. The true cost of energy is not limited to the price we pay for our utilities or at the gas station, but also includes what we eventually pay in terms of degrading the quality of life by ruining the environment and our health. Additionally, the energy sector, petroleum in particular, is highly subsidized by the government in terms of various tax incentives, low-cost access to leases, mapping, R&D on oil extraction, building pipelines, highways and other infrastructures, and finally by military expenditure to protect the flow of oil. According to one estimate, in the last 30 years, the US has spent a total of $230 trillion dollars (1998 dollars) for oil imports (1). The government additionally spends somewhere between $100 billion and $300 billion on hidden costs like health care and lost productivity and another 6 to 60 billion dollars defending oil supplies in the Middle East every year (2). If the costs associated with the current Iraq war are included, the last figure would be substantially higher. Many other environmental costs such as the destruction of natural habitats and wildlife and the loss of species diversity, which are not commercially traded, cannot be accurately measured and are not included in these figures.
Question: What are the external costs associated with electricity generation using solar and other renewable energy sources?
Answer: Although photovoltaic cells emit no pollutants during operation, their manufacture requires large quantities of hazardous materials, and their ultimate disposal could release toxic elements such as arsenic and cadmium into the environment. Other renewable energy sources incur similar costs; the external costs associated with them is however a lot less than with non-renewable sources.
In a new study by the European Commission, the external costs associated with various energy technologies (fossil, nuclear, hydro, solar, and wind) for generating electricity were estimated. For non-market goods such as health care costs, noise, etc., an evaluation was made on the basis of the willingness to pay for damages or willingness to accept the risks. The external cost of material was estimated from the emission produced during its manufacture. Damages to ecosystems (acid rain, ozone depletion and global warming) as a result of fossil combustion were assessed by estimating the cost of avoidance. Because of different technologies used and material and labor costs, the cost is somewhat different from country to country and from one location to another. Table 2 shows the marginal external costs of electricity production in Germany (3). Data for other countries show similar trends.
As this data suggests, electricity generated by wind energy has a very low external cost. The cost can be reduced even further by eliminating external costs associated with noise by installing wind farms some distance away from population centers. Nuclear energy has no externality with respect to classical pollution costs such as health effects associated with pollutants like particulates and oxides of carbon, sulfur, and nitrogen. The cost of global warming is also minimal and limited to that associated with the construction of the nuclear plant. There are, however, other external costs associated with the nuclear power. When uranium ore is mined, left behind are tailings; spent fuel must also be stored. In addition, there is unaccounted risk from earthquakes, and accidental or deliberate sabotage or attack. The US government has spent billions of dollars to find ways to store the nuclear waste unsuccessfully. The cost of treatment and isolation of radioactive waste for thousands of years and damage from nuclear leaks is almost impossible to predict and therefore is not usually included in any external cost analysis. Because of the liability limits in the US, owners of nuclear plants cannot buy full liability insurance in case of major accidents or terrorist attack. The lack of an insurance market – a market failure – should be a clue that there are unaccounted externalities.
The probability of a major nuclear accident is very low, and therefore externality averaged over all nuclear plants is relatively small. Same goes for possibility of a successful nuclear sabotage. In some countries such as Switzerland, the government pays for hardening their reactors to protect against attack. That is one way to count the external cost, the cost of avoiding the consequence of attack. In the event of an accident, however, and for those directly affected by the accident, the external cost could be extremely high and greatly exceed that of all other forms of electricity generation.
Biomass has a relatively minimal impact on greenhouse gases, as the carbon dioxide emission balances with that which is used up during plant growth. The impact could, however, become more pronounced as price of biomass increases and rainforests are destroyed. Although biomass does not produce greenhouse gases, it is not clean. When burned, it still emits pollutants that are harmful to health and to the environment. The air pollution impact varies greatly depending on the type of biomass, the technology used, and the degree to which emission of pollutant gases into the atmosphere is controlled. Natural gas is relatively clean with respect to criteria pollutants. In terms of its impact on climate change, natural gas is a potent greenhouse gas. How great an impact it has, however, depends on which natural gas technologies are employed. Coal is probably the dirtiest of all fuels. Not only is coal a major producer of carbon dioxide, but it is also a major contributor to the particulates and sulfur dioxide emissions responsible for acid rain and other health effects.
Taxes
One way to internalize the external costs is to impose consumption taxes or pollution penalties. One example is waste disposal, which is taxed in the form of a lump sum fee per customer. For example, every American household is charged $10 a month for garbage collection. In some communities, these charges are included in property taxes or association fees. In either case, there are no incentives for customers to reduce waste. Unlike the US, European taxes are based on a scale starting from a low nominal value and increasing gradually as the volume of waste increases.
Energy is usually taxed indirectly in the form of gasoline and emission taxes. However, this may sometimes cause unwanted consequences. For example, taxing gasoline raises its price and so more people will switch to electric cars. To charge the batteries, electricity generated mostly from dirty coal-fired power plants is used, and the overall concentration of carbon dioxide may actually increase. It is therefore more reasonable to directly tax the pollution (for example by taxing per kilogram of carbon produced) instead of placing indirect taxes on energy usage. Several states have begun imposing pollution taxes directly. Depending on what source of energy is being used, a surplus tax per kilowatt-hour of electricity produced is imposed.
References
(1) Greene, D. L., and Tishchishnya, N., “Costs of Oil Dependence: A 2000 Update,” Oak Ridge National Laboratory, ORNL/TM-2000/152, Oak Ridge, TN, 2000, and data updates, 2003.
(2) Hu, P.S., “Estimates of 1996 US Military Expenditures on Defending Oil Supplies from the Middle East: A Literature Review,” Oak Ridge National Laboratory, Oak Ridge, TN, March 1996.
(3) Report EUR 20198, “External Costs: Research results on socio-environmental damages due to electricity and transport,” European Commission Directorate-General for Research Information and Communication Unit, B-1049 Brussels, Belgium, 2003. Executive Summary at Internet: http://europa.eu.int/comm/research/rtdinfo_en.html.
(4) Toossi Reza, "Energy and the Environment:Sources, technologies, and impacts", Verve Publishers, 2005
Additional Comments
(a) Ceteris paribus, the Latin phrase meaning “other things remaining constant.”
(b) It should be stressed here that, although the demand curve for the market as a whole has a downward slope, individual firms sell their product at a given price. The demand curve is a flat line for individual firms.
(c) By “better off” we only mean in terms of overall economical advantage. If the increase in a country’s income comes with the destruction of cultural values, environmental degradation, and other adverse non-quantifiable social implications, then an average person might actually be “worse off” as the result of the trade.
(d) There are instances when no marginal cost or benefit exists. For example, there is no marginal cost for an extra plate in an all-you-can-eat diner, and there is zero marginal benefit of an extra plate when you are no longer hungry.
Further Reading
Colander, D. C., Economics, 3rd E., Irwin-McGraw-Hill, 1998.
Bosselman, F., Energy, Economics and the Environment, Second Edition, Foundation Press, 2005.
Energy Economics, Science Direct Elsevier Publishing Company. Publishes research papers concerned with the economic and econometric modeling and analysis of energy systems and issues.
External Links
United States Association for Energy Economics (http://www.usaee.org).
International Monetary Fund (http://www.imf.org).
The World Bank (http://www.worldbank.com).