Perfectly Competitive and Monopolistically Competitive Markets
Allocative efficiency refers to the choice of production points on the production possibility curve such that the points are socially preferred. Perfectly competitive firm is taken as a benchmark for allocative efficiency. In perfectly competitive market, the price that prevails in the market always equals to the marginal cost of production. For a particular good price is used as a signal for social benefit. The marginal cost on the other hand not only represents cost of seller but is also a representative measure social cost of the good (Fine, 2016). By following the profit maximizing rule of price equals marginal cost competitive firms ensure allocative efficiency.
In a perfectly competitive industry, all the firm in the long run can enjoy only a normal profit. Suppose a competitive firm in the long run is enjoying a supernormal profit. It then encourages other firms to enter the industry. Entry of new firms continue until only normal profit is left in the industry. During economic loss, firms leave the industry (Baumol & Blinder, 2015). The long run equilibrium holds where price equals minimum average cost which also equal marginal cost.
In a monopolistically competitive market allocative efficiency does not achieve either in the short run or in the long run. Firms in the monopolistically competitive market follow the profit maximization rule as marginal revenue equals marginal cost. Unlike perfectly competitive market, firm face a downward sloping demand curve. The marginal revenue thus is not equal to the price. As price is greater than marginal revenue, it is also higher than marginal cost. When price exceeds in marginal cost, benefits that society gets from additional unit of output reflected in the price exceeds the social cost of providing the good (Moulin, 2014). In the long run, firms though have only normal profit but still output is less than socially efficient outcome. The socially efficient outcome corresponding to minimum point of average cost. Monopolistically competitive firm in the long run operates to the left of minimum of average cost. There exists an excess capacity in the industry. In the monopolistically competitive market, firms using its market power produce a lower quantity and charges a higher price. This explains existence of allocative inefficiency in monopolistically competitive market.
In designing environmental policy, the market based instruments are defined as policy tools that works through market mechanism and use price or other economic variables in order to provide incentive to the polluters for eliminating or reducing negative externality harming the environment. It is a self-correction mechanism that addresses the problem of market failure resulted from externality.
Two commonly used market mechanism used for controlling pollution as an externality is tax and transferrable pollution permit.
The mechanism of transferable pollution permit sets a certain level of pollution. This provides firms a legal right to pollute the set amount of pollution. It is possible for some firms to reduce pollution at a lower cost than others. As the concerned firm can reduce pollution at a lower cost it trades the permit to other firms. Others who are unable to reduce the level of pollution demand permits from other firms or government (Friedman, 2017). This creates a market of pollution permit where permits are traded at certain prices. Objective of the pollution permit is to offer market incentive to firms to internalize the external cost of pollution.
Transferable Pollution Permits
In the market for pollution permit, the supply of permits fixed at Q1. The demand for permit depends on the firms’ ability to reduce pollution. If the demand for pollution increases then demand curve shifts from DD to D1D1 leading to an increase in cost of permits from P1 to P2. Firms therefore has own incentive to reduce pollution rather than paying a high price to obtain tradable permits.
Under the market based approach of tax, the maximum cost for implementing pollution control measures are determined. The polluters here have an incentive to lower pollution at a relatively low cost rather than paying a tax. Unlike pollution permits, no upper limit is set for pollution. The level of pollution rather depends on the implemented tax rate. The imposed tax is generally equivalent to the external cost determined from the difference between marginal social cost and marginal private cost (Cowen & Tabarrok, 2015).
S1 curve shows the marginal private cost of the polluting firm. The D1 curve shows marginal benefit as usual. The free market equilibrium is at E indicating market price and quantity as P1 and Q1 respectively. In the presence of negative externality of pollution social marginal cost exceeds the private marginal cost. Now, imposition of a tax of ‘t’ equivalent to external cost shifts the supply curve upwards to S2. This reduces pollution to Q2 and raise price to P2. This is how tax works in combating pollution.
Firm and industry supply curve in an increasing cost industry in explained in figure 5. Panel (A) of the figure shows long run supply curve of the firm and industry supply curve is show in panel (B). Point E indicates the initial equilibrium point of the firm. At this point, the firm is producing output using plant A. The produced output is ON while cost incurred by the firm is OP. Now consider an increase industry demand reflected from a rightward shift of the industry demand curve from DD to D1D1. This shifts the industry equilibrium point from its initial equilibrium position of A to B. This raises equilibrium price from P to P1. The high price increases profitability of firms operating in the industry results in entry of several new firms in the industry. As more firm enter the market, there is an increased demand for factor inputs (Nicholson & Snyder, 2014). In the increasing cost industry, the higher output results in a higher cost. As a result the cost curves shifts upward. With higher cost firms chose to use a small size plant and operate at point E1. The corresponding output for firm is OM. The supply of each firms though decreases but the overall supply in the industry increases because of the presence of larger number of firms. The industry output increases from Q to Q1. The industry equilibrium shifts from point A to point B. The long run industry supply curve is AB.
Figure 6 explains the long run supply curve for the firm and industry with a constant cost of operation. As before, panel (A) shows revenue, cost and supply of the firm while panel (B) shows the same for the industry. The firm is in equilibrium at point E producing OM output. The corresponding equilibrium for the industry is at A. The increase in industry demand again raise price and attracts new firms to enter the market. The entry of new firms does not change the cost condition. The cost curves do not shift upward and the firms continue to operate with same LAC. The entry of new firms just shift the industry supply curve to the right (Mochrie, 2015). The new industry equilibrium point is at B. At the new equilibrium, output increases both for firm and the industry. The long run supply curve in a constant cost industry is thus a horizontal straight line.
Tax-Based Approaches to Controlling Pollution
Income elasticity measures the percentage change in quantity demanded in response to a corresponding percentage change in income (Fine, 2016). From the measure of income elasticity, the expected change in demand can be estimated for an expected change in income. The income elasticity for pre-recorded music compact disc is +7. This means 1 percent change in income will lead to a 7% increases in demand for pre-recorded music compact disc. Therefore, the economic expansion that increases consumer income by 10% will result in a (10*7) = 70% increase in demand pre-recorded music disk. For cabinet maker the income elasticity is 0.7. 10% increase in income resulted from economic expansion thus can increase the demand by (0.7 * 10) = 7%. Increases consumers income by 10% thus results in a greater proportionate increase in demand for pre-recorded music disk as compared to cabinet makers. The sales of pre-recorded music disk will increase more than that for cabinet makers after increase in income.
A simple way to understand whether pre-recorded music disk and MP3 player are in competition or not is to compute the cross price elasticity of demand. The cross price elasticity captures percentage change in demand for a corresponding proportionate change in price of some related good. A positive value of cross price elasticity implies that an increases in price of any one of them though have an adverse effect on its own demand but have a favorable impact on demand of the other. In this case the two products are identified as substitute to each other and hence, intense competition exists between them (Ashwin, Taylor & Mankiw, 2016). A positive value of cross price elasticity on the other hand implies that the products are complementary to each other and hence, there is no competition.
A good can be classified as normal or inferior depending on the relation between demand and income. A positive relation between demand and income implies the good is a normal good. On the other hand, if demand falls along with an increase in income then the good is inferior (Friedman, 2017).
YED = +0.6
This implies one percent increase in income leads to a 0.6% increase in demand. The proportionate increase in demand is less than the proportionate increases income. The good thus relatively income inelastic. As demand increases with increase in income, this is a normal good. The elasticity is less than one implying the good is a necessary one.
YED = -2.6.
The income elasticity measure indicates that 1 percent increase in demand causes a 2.6% decrease in demand. As demand decreases with an increase in income the good is an inferior good. The measured elasticity in greater than 1 implying proportionate change in demand is much greater than that of income. The demand thus is relatively income elastic.
XED = +0.64.
The estimated elasticity indicates 1% increase in price of the related good lead to a 0.64% increase in demand for the concerned good. The positive cross price elasticity implies that demand for the good increases when price of the related good increases. This is the case for substitute goods. The two goods in the question is thus substitute to each other. When price of a good increases, demand for the good goes down while demand for the substitute goods increases. This explains the positive cross price elasticity for substitute goods.
XED = -2.6
The elasticity measure implies 1% increase in price of the related good lead to a 2.6% decrease in demand for the concerned good. The increase in price of related good thus not only reduces its own demand but also causes a decline in demand for the good in question. This is the case when two goods are complementary.
At price $8 per unit the firm should produce 70 units of output in order to maximize profit.
The average cost of production at this price is $6.
The firm should produce 50 units of output to maximize profit at price $5.
At price $5, price equals the minimum of average cost. Here, total revenue equals total cost and hence no supernormal profit is earned.
At price $4 per unit the firm should produce 40 units of output in order to maximize profit.
Price is now less than average cost. Total revenue is therefore less than total cost. The firm therefore incur a loss at this price.
At price below $3.5 the firm should shut down in the short run. This is the price below minimum average variable cost.
At price below $5 the firm should shut down in the short run. This is the price below average cost.
Reference list
Ashwin, A., Taylor, M. P., & Mankiw, N. G. (2016). Business economics. Nelson Education.
Baumol, W. J., & Blinder, A. S. (2015). Microeconomics: Principles and policy. Cengage Learning.
Cowen, T., & Tabarrok, A. (2015). Modern Principles of Microeconomics. Palgrave Macmillan.
Fine, B. (2016). Microeconomics. University of Chicago Press Economics Books.
Friedman, L. S. (2017). The microeconomics of public policy analysis. Princeton University Press.
Mochrie, R. (2015). Intermediate microeconomics. Palgrave Macmillan.
Moulin, H. (2014). Cooperative microeconomics: a game-theoretic introduction. Princeton University Press.
Nicholson, W., & Snyder, C. M. (2014). Intermediate microeconomics and its application. Cengage Learning.
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