Market Efficiency Issues - Assignment Example

1(a) Market Structure and efficiency Efficiency in market relates to a situation in which where it’s not possible to increase overall welfare in thesociety. Though it may be possible to increase someone’s welfare but that would only come at a cost of other’s welfare. This seemingly inconsistency should not confuse as what this means is in an efficient market the best possible arrangement has been achieved and there is no room for further welfare which also implies that there is zero wastage in the economy. Market structure that is prevailing state of competition determines prevalent efficiency in the market. The efficiency could be of two types productive and allocative where the former refers to how efficient is the production i.e. least cost and the latter one that reflects the goods and services are produced according to their value for the customers. The 100% efficient market is an ideal concept just like perfectly competitive market with no existence in reality. But some markets come quite close to being efficient. The concept of efficiency determination by market structure was offered by Adam smith. He was of view that if perfectly competitive markets in their pursuit of self interest ultimately result in to efficient market. As the market moves away from perfect competition to imperfect competition, the efficiency goes down. We can compare Forex markets (very close to perfect competition) with personal computer market. The Forex market is very efficient in comparison to personal computer market. We can understand the reason for the difference in the efficiency with the help of following graphs which depict profit maximizing conditions for both a perfectly competitive and imperfectly competitive markets. Graph (1) representing profit maximization point for a perfectly competitive market ( Forex market) We see in the graph that the profit maximization point is q0 where MR = MC. We also know that in perfect competition MR = AR = P = D as depicted in the graph above. Thus we see that in perfect competition at profit maximizing point MC = P = D which means MC = MU, that means the marginal benefit accruing to the society is exactly equal to the marginal loss to the society (MC). Thus at this point the efficiency is highest and moving from this point will decrease the efficiency but a firm in competitive market will not be motivated to do so i.e. move away from MC = MR. . . Graph (2), representing profit maximization for Monopolist. (Personal computer market) - The profit Maximizing point for a monopolist will also be at MR = MC. In this graph MR = MC is where output is 10 at price 50. Since at this point price is higher than MC i.e. d > MC. In this case it’s possible to increase the welfare in the society by producing further as long as MC is smaller than price. Which is actually a case where Q =10. So to increase efficiency a monopolist should produce more but that will reduce the profits thus monopolist will restrict at this point leaving market inefficient. Total physical product of labor Marginal Physical Product of labor Price of Product Total revenue Marginal Revenue Product Wage Total factor cost Marginal Factor Cost Total profit # (TPPL) (MPPL) (P) TR (MRP) (W) TC (MFC) T P 1 16 16 10 160 160 70 70 70 90 2 36 20 10 360 200 70 140 70 220 3 60 24 10 600 240 70 210 70 390 4 86 26 10 860 260 70 280 70 580 5 110 24 10 1100 240 70 350 70 750 6 130 20 10 1300 200 70 420 70 880 7 146 16 10 1460 160 70 490 70 970 8 160 24 10 1600 240 70 560 70 1040 9 170 10 10 1700 100 70 630 70 1070 10 176 6 10 1760 60 70 700 70 1060 Answer 3 a) Answer 3 b) – There can be two reasons for the fixed wage level i.e. 70. 1) The government might have fixed 70 as minimum wage to be paid and market rate for labor is lower than 70. 2) The market for labor supply can be highly competitive thus irrespective of the fact how much labor does the firm employs price remains the same i.e. 70. Ans 3 c) - The product market must be perfectly competitive as the demand curve does not slope downward but rather stays straight and parallel to X axis which is a characteristic of perfectly competitive markets. Ans 3 d) The Company must hire 9 workers to maximize its profit. As this is the point where the difference between MC and MR though not zero but is the least. The rule for profit maximization is MR = MC If MC < MR then firm must increase its production until MC becomes equal to MR And IF MC > MR then firm must cut back on its production to restore MC = MR. Revenue and Cost curves Total Cost and total revenues curves. The straight lines connecting the curves are the profits at each point. We can easily see in the graph that the longest line is at labor 9. This is how much should the company hire. Ans 3 e) The result of hiring any other number of workers is as follows 1) If the firm were to hire less than 9 workers we find that the difference between the MFC and MRP will be higher. We can see that MFC is below MRP thus adding more labors will increase the revenue by a greater amount than the amount of cost increase. Thus adding more workers would increase the amount of profit up to 9 workers. 2) Hiring more that 9 will also not make sense as the gap between MFC and MRP increases again but here MRP is less than MFC, which suggests we are offsetting some of our profit as the 10 or 10+ labor will have higher cost than the MRP it would bring. Thus we are letting go some of the profits that we made up to 9 workers. Answer 2) One shot prisoner’s dilemma is a game situation in which two (or more) competing parties have different strategies to choose from, and both of them know the strategies available to each one of them. They are also aware of the fact that they can maximize their overall profit or gain (or minimize over all loses) by cooperating with each other however if they decide otherwise i.e. they don’t cooperate and choose to compete they nullify each other’s actions and both end up losing valuable resources for no benefit. IF one of them chooses to cooperate while the other competes then the cooperating firm looses heavily to the competing firm. This situation can be witnessed in real life. One relevant example of this was the situation faced by cigarette companies in America. They realized that they were spending their money on advertising which was not brining any extra sales overall and individually also. But they did not cooperate and kept spending on advertising because every firm would rationally think that if I do not advertize and my competitors do then they will take away my market share. Thus every firm, thinking logically, takes the same decision of not letting their competitors take their market share away. They all end up spending heavily on advertising. b) In oligopoly market structure if there is no potential to increase the industry demand then spending money on advertising or waging price wars will not help any company. Though if it were to be just one firm who would advertize or lower the price then it could get increased revenue, but all firms acting rationally follow the strategy of playing safe and not letting their competitors any chance to sucker them. Thus everybody ends up spending heavily on advertising or price cutting with no extra revenue. To appreciate this, we will use a model of prisoner’s dilemma game. Consider a duopoly market with two firms Pelsi (P) and Cola cola (C), both enjoying sales of 10m each and the industry sales is 20m, The firms have two choices with them either to decrease the price or keep them high. The pay offs of each strategy will be If both P and C keep the price same the price – the revenue remains the same i.e. 10 m each. If P maintains the price as earlier and C reduces the price then P loses 50 % revenue to C and vice versa If both keep the prices reduce the price, then their revenues fall by 20 5 each i.e revenue figures will be 8m each. The pay off matrix for both of them is Firm / Strategy C (price same) C (price cut) P (price same) 10m 10m A 15m 5m B P (price cut) 5m 15 m C 8m 8m D Different pay offs are shown in the cells A, B, C and D The firms should operate at cell A where both will be better off but they would rather choose cell D. The reason for this simple Let’s consider firm P. P sees the matrix and realize that to whatever be the C’s strategy. It one strategy dominates for it i.e. price cut. And P will also realize that the same condition holds for C also and thus P would assume that C acting rationally will also choose its dominant strategy i.e. to cut the price and both firms end up cutting the price with net loss of 2 m each. Had there been some possibility of making sure that the other person also cooperates then any firm would choose to keeps the price same or even hiking them. Same holds true for advertising also and firms end up spending heavily on advertising with no gain. Ans 4) Private players are interested in profit while the government’s is not profit but to serve the society. Thus the goods that private markets cannot produce efficiently or profitably become government’s responsibility. Thus the government intervenes and produces such goods. Such goods are called as “public goods”. These goods have some unique characteristics which make them unprofitable to private firms to produce. The characteristics are Non Rival consumption – If consumption of some goods is such that they can be consumed simultaneously by two people and consumption of one does not prevent others from enjoying its benefits then such goods are called as Non rival goods. For example travelling by another passenger does not affect travelling of somebody else. When marketers realize that the non payers or non purchasers also enjoy the benefit supplied to the payers and the marketer cannot exclude non payers or purchasers from enjoying the service then this becomes problem for the marketers as it leads to free riding., The problem of free riding also makes earlier buyers think that they can also the benefits even not paying for it. Thus they also think of not buying and private players find fewer buyers for their products. In such situation government has to intervene. For example in an apartment if somebody refuses to pay for outer painting of the apartment, he or she can still enjoy the paint afforded by a few. Since he can’t be stopped from using it and cannot be made to pay for it, they have to form a government like structure and thus society has to take care of collecting revenue and getting common things done for others. Thus similarly for other public goods a government intervention is required. Apart from free riding there could be other reasons for government to intervene, which warrant government’s intervention in producing these products. The externality can be understood as a phenomenon which applies when one firm can enjoy benefits at the cost of others like society without compensating them fully for that or one firm benefits others and does not get compensated. The former phenomenon is known as negative externality and the latter one as positive externality. The examples of which are as Positive externality – Eg Positive externality – if a firm finds that it invests in R&D and benefits are reaped by others also without paying for it i.e. by simply copying its inventions the firm may not see any logic in investing. Plz refer diagram 1 Fig- 1. Positive consumption externality Fig 1 In this figure D reflects the marginal private benefit, that reflects what people are ready to pay, but D1 being higher than D shows that society will be deriving some more benefit than they pay for, which would discourage the firm from producing Q* = 12 and it would restrict its supply to only Q = 10. Eg negative externality – if the firm pollutes environment without having to pay for this in nearby river without paying for it, then the firm would want to produce more than when the firm would have to pay for the pollution that it caused.. Fig 2. - Negative production externality Fig 2 In this case the producer the producer may want to produce 5 units as for it the costs are lower (it does not have to pay for pollution) but when government steps in and start . Taxing for pollution the firm will have to pay for it and the cost would increase and the firm will have to bring production down. Other reasons for government intervention could be Moral Hazard and Adverse selection. Considering above issues the importance of government’s intervention cannot be ruled out as if non-rival consumption goods are to be produced or pollution and other social hazards are to be discouraged and innovation and R&D are to be encouraged only private players cannot get the desired results. After all, the “invisible hand concept” of Adam Smith had many assumptions which do not play out in real world. References Samuelson, P. and Nordhaus, W. (2007) Economics, 18th edition, pp. 128-131, Tata McGraw- Hill, Hubbard, G. and O’Brien, P. (2008) Microeconomics, 1st Edition, pp. 354-364, Pearson Education. . Read More