Perfect Competition - Protectionism - Case Study Example

Perfect Competition: Perfect competition is a market situation characterized by the existence of numerous buyers and sellers, of a homogenous productor service, with zero market power. Perfectly competitive firms can enter or exit the market freely and hence a single buyer or seller cannot influence the price of the good or service (Todaro and Smith 2002). The following paper explains the characteristics of a perfectly competitive market and analyzes the practicability of this model in the real world setting. The model of perfect competition is built on the following assumptions (Bamford 1999): 1) Firms are price takers: In a perfectly competitive market, there are so many firms that an individual firm contributes insignificantly to the total industry output and hence has no power to determine the price. Due to this, a perfectly competitive firm has a horizontal demand curve and the market price is determined by the interaction between demand and supply and all the firms offer the same market price to the consumers. 2) There are no barriers to entry or exit: In a perfectly competitive industry, a firm can enter and exit the industry freely. There are no costs of entering the market. For example, a farmer does not have to incur a lot of investment to grow wheat and hence can enter the market easily. But a car manufacturer needs a lot of capital investment to buy machinery and hence it is not easy to enter the market. 3) All firms produce a homogenous product: All the firms in a perfectly competitive industry sell identical products. Hence there is no advertising or branding of the products. 4) Producers and consumers have perfect knowledge of the market. Producers are fully aware of the price, cost and market opportunities and the consumers have complete knowledge about the price, quality and availability of the product. 5) Large number of buyers and sellers: A perfectly competitive industry has a large number of buyers and sellers and hence any one producer or buyer can not influence price or output. For example, small farmers produce an insignificant amount of the total output and hence have no influence over price. 6) Profit maximization: The profit of a perfectly competitive firm is maximized when its marginal cost equal its marginal revenue. Since the there are no entry or exit barriers, firms only earn normal profit in the long run. Normal profit is the minimum level of profit required to persuade firms to stay in the industry but not high enough to attract new forms. Few, if any, industries in the real world meet the above conditions. One of the important reasons why perfect competition does not exist in the real world is the economies of scale. In most of the industries, a firm has to be quite large to experience economies of scale. But in perfect competition, firms have an insignificant market share and are too small to achieve economies of scale. Once a firm expands and achieves economies of scale, it would lower it costs and gain market power. The firm can reduce the prices and drive out the smaller firms from the industry. Hence a perfect competition can only survive in an industry where there are no economies of scale. Conclusion: Although the perfectly competitive market model is not applicable to the real world setting, it plays a significant role in economic analysis and policy. The model can be used as a criterion to judge the deficiencies of the real world industries and can help government to articulate policies towards the betterment of the industry. Protectionism: Free trade leads to an increase in the world economic welfare but still countries adopt policies that prevent free trade. These policies are adopted to give a competitive advantage to the domestic industry of an economy. Such policies are called protectionist policies because they provide some degree of protection to the domestic industry from foreign competition (Samuelson and Nordhaus 2001). This paper analyzes the arguments for and against protectionism and the role of WTO in promoting free trade in the world. Countries use various methods to protect their domestic industry. Countries often use protectionist policies to: 1) Safeguard infant industries: Import barriers such as tariff and quotas are imposed by the government to safeguard infant industries from foreign competition until those industries achieve economies of scale. 2) Prevent dumping: Dumping is a process of selling goods in a foreign market at a price below its domestic sales price (Lipsey and Chrystal 2001). The purpose of dumping is to prevent existing competition in the foreign market. Hence countries use protectionist policies to prevent dumping. 3) To prevent import of harmful goods: Government also uses protectionist policies to restrict the import of harmful goods such as tobacco, alcohol, recreational drugs and all goods that have adverse social effects. However the protectionist policies may lead to undesirable outcomes as mentioned below: 1) The infant industry argument is valid only if the industry achieves economies of scale. However, in most cases, such infant industries remain inefficient and costly to operate due to the protectionist policies pursued by the government. 2) Due to the protectionist policies, consumers suffer as they have to buy the low quality and costly domestic products. 3) When a country imposes protectionist policies, other countries retaliate by using the similar policies and this may lead to trade wars. Protectionist policies may help a country’s economy but such policies reduce the overall economic welfare of the world. Hence the world trade organization (WTO) was established in 1995 to create an environment in the world economy that is conducive to free trade. Following are the rules of WTO that helps in promotion of free trade (Sloman 1999): 1) Most favored nation clause states that any concession that a country makes to one member must then be granted to all the member states except free trade areas and custom unions. 2) If a country gains from a tariff reduction by another country, that country should also make reductions in tariff itself. 3) Prohibition on quotas. 4) Member countries should not take retaliatory action against countries it suspects of unfair practices. Conclusion: Imposing protectionist policies may have an adverse impact on the economic condition of a country. Hence Government should assess the costs and benefits of implementing protectionist policies. WTO has promoted free trade over the years by reducing the trade barriers. WTO rules eliminated formal barriers but many hidden barriers still remain. Hence WTO should formulate rules that reduce such hidden barriers and promote free trade among countries to increase the overall economic welfare of the world. REFERENCES Todaro, M.P. and Smith, S.C., 2002. Economics Development, 8th ed., Addison Wesley. Bamford, C. et al., 2002. Economics: AS and A Level. Cambridge University Press. Samuelson, P.A. and Nordhaus, W.D., 2001. Economics, 17th ed., McGraw-Hill. Lipsey, R. and Chrystal, A., 2001. Economics, 9th ed., Oxford University Press. Sloman 1999. Sloman, J., 1999. Economics, 3rd ed., Prentice Hall Europe. Read More