Perfect Competition

Perfect competition is a very unrealistic market structure. We'll discuss the characteristics of it later, but for now we have to understand that it is a theoretical concept. If the world was perfect then in most cases we'd have markets operating 'perfectly'. The world isn't perfect and therefore actually seeing perfect competition in reality is a long shot. The major assumption we make is that firms are price takers. By this we mean that each firm alone has no influence over the market price because of their relative size. They take the price they can get as given and perceive it to be constant. Therefore the demand curve for a firm in perfect competition is horizontal - the can sell as much as they want but only at the market set price. Any higher and they wouldn't sell a thing, any lower and they'd make a loss in the long run.

Here we have a typical perfect competition scenario in the short run. On the left is the market where the market price is determined by the supply and demand for the good. The firm, on the right, takes the market price as given and as their price. Average revenue and marginal revenue is the same as the demand curve because we are looking at a constant price for the good. Production takes place at the point where MC = MR, anywhere before this point and more profit can be made, anywhere after this point and profit falls. If you look at the diagram, at the point MC = MR, the average cost is below the average revenue. This means profit is available, which is shown by the yellow area. In the short run the supernormal profit will be (AR-AC) x Qe.

Now, above I've just said that AR and MR are the same as demand because price is constant. You want proof I hear? Sure thing. Average revenue = Total revenue / Quantity. Total revenue is actually price x quantity. Therefore average revenue can be re-written as (price x quantity) / quantity. Quantity cancels out leaving price ~ average revenue = price. Marginal revenue = the change in total revenue / the change in quantity. Substituting in what total revenue actually is we have the change in (price x quantity) / change in quantity. The change in quantity cancels out leaving price ~ marginal revenue = price. Boom!

But, we have only discussed the short run. These supernormal profits don't go unnoticed - they attract new firms into the industry. Supply now shifts out.

The price falls due to the increase in supply. On the right diagram we can see that it's fallen to the point where MC = MR = AC. This means that supernormal profit is no longer being made, it has been competed away. At this point no more firms will enter the industry because there won't be the pull of supernormal profits. Therefore, in the long run there is no supernormal profit to be made in a perfectly competitive market.

It seems risky to the normal person, producing right on the point of breaking even. This is true to a certain extent. Shocks to the system could cause demand to fall, what would happen to the firm then?

Here we have the case of a fall in demand in the market causing a fall in price. The firm was initially producing where MC = MR = AC, but now the fall in price means that if they produce at MC = MR they will actually be making a super-normal loss. This point would be below average costs and therefore the enclosed area on the right hand diagram would be loss. Would they carry on producing? Surprisingly, yes, in this case the firm would. To understand this we have to look at the breakdown of the costs. In the short run we know capital is fixed and labour is variable. Therefore the average variable cost for the firm in a simple world would be labour costs / quantity. As long as the average revenue (demand curve) is greater than the average variable costs then the firm will continue producing. This means they can cover the costs of labour and make some contribution to the fixed costs. If they couldn't cover the average variable costs it would be better for the firm to stop producing, lay off all the workers and only lose the fixed costs.

Some other things we can state is that the short run supply curve for a firm in a perfectly competitive market is the marginal cost curve until the point where price equals average variable cost. As we said above, below that point the firm will stop supplying the market. In the long run the firms supply curve is horizontal at the minimum average cost.

All we need to do now is sum up whether perfect competition is a good thing. It definitely has its advantages, they are as follows:

·         It's efficient - production occurs at the lowest average cost which is the most efficient point.

·         Competition - competition in an industry forces firms to be more efficient.

·         Price is influenced by demand - the market is essentially run by consumers, it responds to their behaviour.

·         No supernormal profits in the long run.

It really has few disadvantages though. You could state the fact that it isn't realistic as a disadvantage, I guess. In real life it would be rare to find a market with freedom of entry/exit, identical products, price taking firms, etc. One point that could be made about the lack of super-normal profit is the lack of innovation. Innovation tends to be fueled by profit, without profit there is little room for firms to innovate. Innovation is one thing that can lead to a more efficient market, so in perfect competition once the efficient point is reached it will not be made any more efficient. Comprende?

Sam.

Statistics - Sampling Methods and Estimation

In statistics we have to use samples because it's normally near on impossible to get data for the entire population. As long as the sampling is done well, the results will usually be good enough. Logic would tell you that the larger the sample, the better.. and this is true. There are two concepts we need to understand here, those are random sampling and sampling distribution.

• Random sampling - The goal of this is representativeness, we aim to get an equal probability of selection to every member of the population. There are a few methods:
• Simple random sampling - A sample so that every item or person in a population has the same chance of being included.
• Systematic random sampling - Items or individuals are arranged in some sort of order. A random starting point is selected and then every nth member is selected. Alphabetic order for example. 
• Stratified random sampling - A population is divided into sub groups (strata) and a sample is selected from each strata.
• Cluster sampling - A population is divided up into primary units and then samples are selected from the primary units.
• Non-probability sampling - Inclusion in the sample is based on the judgement of the person selecting the sample. (Eeek!)

• Sampling Distribution - This is the theoretical distribution of a statistic for all possible samples of a certain sample size, N. It's a device to link the samples characteristics to the population.
• If repeated sample sizes of size N are drawn from a normal population with a mean of mew and a standard deviation, σ, then the sampling distribution of sample means will be normal with a mean of mew and a standard deviation of σ / SqrRoot(N).
• The 'Central Limit Theorem' states that if repeated samples of size N are drawn from a population, as N becomes large the sampling distribution or sample means will approach normality.
• Or, in easier terms: Large samples are more reliable!

The more basic method of estimation is confidence intervals. From a sample we don't know the population mean, but we would like to estimate this with maximum efficiency. To do this we use a range, and say how certain we are that this range includes the population mean. We give a confidence interval in the form of a percentage, for example we could say that at a 99% confidence interval, between 33% and 39% of adults will vote for Labour in the next election (Made up!). A bigger confidence interval is more likely to contain the true population mean.

The next post will go further into the concept of confidence intervals and we will introduce such things as error margins. Stay tuned, thanks guys!

Sam. 

Common Agricultural Policy Part 2 - Declining Farm Incomes

The next thing the CAP aims to eradicate is declining farm incomes. These are mainly caused by two things: low income elasticity of demand and/or increases in supply. As usual, we'll display this diagrammatically. Lets suppose we have a fairly inelastic demand curve and at the same time farm efficiency has improved, we can expect the market to now look as follows:

We can see that prices have fallen from P1 to P2 and quantity has risen from Q1 to Q2. However, we can also see that this has caused a fall in income of area a and an additional income of area b for the farmers. Area a is clearly larger than area b, meaning the farmers income as a whole has fallen. The way for farmers to gain is for demand to shift out by a larger amount, as even a small shift in demand would leave farm incomes still falling. 

What the farmers need is a more elastic demand curve for any increases in supply efficiency to actually increase farmers income. However, demand for grown crops is generally more inelastic because it's a necessity and therefore a change in price really doesn't affect demand all that much. This is why the government needs to intervene with the CAP because else there would be no incentive for farmers to make their production mechanisms more efficient as they'd effectively be losing money due to it.

Now we have covered both reasons as to why the CAP is necessary; fluctuating crop prices and declining farm incomes. We will next cover how the EU uses it's policies to correct these issues. Stay tuned!

Sam.

Preferential Trading Arrangements

Preferential trading arrangements refer to such things as trade blocs. Trade restrictions are held with the rest of the world but lower restrictions or none with member states. There are three types of preferential trading arrangement:

• Free Trade Area - This is when member states remove tariffs and quotas with one another. However, restrictions on trade with non-member states are kept individual to each nation.
• Customs Union - This is the same as above, but in addition there are common external restrictions on trade with non-member states. 
• Common Markets - This takes it one step further and the members operate as a single market. This means as well as the features of the above arrangements there is also a common taxation system, common laws regarding production, employment and trade, free movement of labour and capital and no special treatment by governments to their own domestic industries. Additionally to this, we sometimes see fixed exchange rates between members and common macroeconomic policies. 

Next we move on to trade creation and trade diversion, which come as a result of preferential trading arrangements. First, trade creation. This is when consumption shifts from a high-cost producer to a low-cost producer as a result of of joining the customs union. Normally this is due to obtaining the goods cheaper from other members of the union. As with most things, this can be modeled on a diagram! 

Trade Creation Diagram

This is it, the trade creation diagram. Let's explain it a bit. SDom and DDom are the domestic supply and demand of a good. Before the EU, the country had to pay at the 'PEU + tariff' price so domestic production was at Q2 and domestic demand was at Q1. The imports here were the difference between Q1 and Q2. With the joining of the EU, the price was now the PEU price, lower than before. This meant domestic supply had fallen to Q4 and domestic demand had risen to Q3. So the new imports level is the difference between Q3 and Q4, which is higher than before. Thus, trade has been created. 

Trade diversion works in very much the opposite way. This is when consumption shifts from a lower cost producer outside the customs union to a higher cost producer inside it. There is a net loss in world efficiency now the higher cost producer is being used. 

Trade Diversion Diagram

This is the trade diversion diagram. The country was initially paying price P1 for the good, meaning they consumed at Q1 and produced at Q2. Price falls to P2 because of the joining of the EU. We can see here, that consumer surplus has improved. The original consumer surplus at price P1 has now increased to include the areas 1, 2, 3 and 4 on the diagram. We also notice a loss of producer surplus by area 1 which will be the fall in profits. No tariffs are paid out anymore, so the areas 3 and 5 are lost to the government in terms of revenue. This leaves an overall net gain of areas 1 + 2 + 3 + 4 - 1 - 3 - 5 = 2 + 4 - 5. Here we can decide whether the trade diversion has been beneficial or detrimental. If the size of area 5 which we have lost is greater than the size of areas 2 plus 4 which we've gained then there is a net loss, otherwise we've achieved a net gain. 

If there are high external tariffs or a small cost difference between goods produced inside and outside of the union then a customs union is likely to lead to trade diversion.

In the long term, a customs union could have advantages and disadvantages, I'll name a few of both:

• Advantages:
• Increased market size - allows firms to potentially exploit economies of scale to lower costs.
• Better terms of trade with world markets because of the power of the customs union.
• Increased competition which will stimulate efficiency and bring costs down.
• Disadvantages:
• Resources may flow to the geographical centre for the lower transport costs leaving depressed regions on the edge of the union.
• Mergers will be encouraged which will boost monopoly powers.
• Diseconomies of scale.
• The administration costs of maintaining the union.

The basics of preferential trading arrangements in one blog post, tadaaa! Thank you for reading, keep sharing and following the blog! Thanks guys, have a good day.

Sam.

Debate: Transport for the Olympics?

I thought I'd throw my opinion out there on the transport system for the London 2012 Olympics in today's blog post. First and foremost, I think on paper the transport ideas sound like a great idea. The whole idea of making it easier for people to access the events of London 2012 and the Paralympic games economically should be a very sound move. Bear in mind when reading that prior to the Olympics, the games were expected to boost the economy in the short term and the long term. Now that such data has appeared that seems to suggest the Olympics haven’t really achieved that much economically - can we partly blame the transport system?

Mervyn King was reported to have told the Daily Mail that the "the happiness won't last long..." in regards to the short term economic surge caused by the Olympics. More about this story can be read by clicking here. Therefore, economically the consensus is that the games haven't achieved that much, despite the years of planning and millions of pounds of investment. Obviously I understand that nothing can be predicted accurately at this stage, so time may prove Meryvn wrong - which is what we all hope. I think the fact Meryvn has gone so publically with this negative outlook is disgusting, as if there isn't enough bad economic news around as it is. I know people will argue that we have a right to know about these things, but I'd say most people already don't expect much in the next few years economically and the fact that Mervyn has just confirmed this will not install confidence in anyone. The doom and gloom merchants need to keep some of their thoughts to themselves!

I'd like to look at both the London Underground system and the Olympic driving lanes in this debate as these are two of the Olympic transport policies that I have experienced during the games. Firstly, the London Underground. I encountered this at peak time in the middle of the games and I have nothing but praise for the planners. It was seamless, I made a trip into Waterloo and from there I had to get the Victoria Line and then the Northern line through to London Kings Cross. Bearing in mind this was at peak time, so I was expecting crowds of workers as well as Olympic go-ers, I was pleasantly surprised. Everything ran smoothly - I was on and off the Underground painlessly and I have nothing but praise for the. The return journey, also a peak time (the evening this time), was seamless as well. I experienced it twice during the games at peak times and I thought it was great, obviously there will be people who used it a lot more and saw a lot more that went on, but on the whole I think it ran smoothly. Therefore, economically I think the investment that went into the London Underground was very beneficial and justified. Not only were workers in London still able to get to work on time but the extra travellers heading to the games were also catered for and this can only have benefited the economy. My problem occurs when it comes to the Olympic lanes...

The few times I encountered the Olympic driving lanes were around 10 - 11 am. I wasn't heading to the games so therefore I was in the 'normal' lane, queuing, whilst watching the empty lane next to me remain... empty. One occasion, on route to Staines, it took me 25 minutes to travel a mile as all the traffic had to bottleneck into one lane, all whilst a perfectly fine lane lay empty next to me. During those 25 minutes the Olympic lane wasn't used once. This was beyond frustrating, this lane seemed redundant during this time, a waste of space even, yet we couldn't use it and had to queue up in traffic - delaying arrivals to our destinations. Infrastructure is always a big point in the economy, and in my opinion I think this is evidence of it failing. The lanes were unnecessary during the Olympic sessions and should have been opened to all traffic. Already, according to the Daily Mail, Londoners waste 66 hours a year stuck in traffic. 66 hours that could be spent working, benefiting the economy. Turning normal lanes into these Olympic lanes is only going to have added to this figure and that is no way to benefit the economy when we're in a rocky situation. In my opinion, the Olympic lanes weren't thought out too well and didn't function efficiently - but, what is my opinion worth anyway?

I'd like to conclude by saying that I think the Olympics will be successful economically for us. The sense of national pride and 'togetherness' that seemed to shine during the games surely has to have some effect! The London Underground, like I said, was very good during the games but the Olympic lanes let the transport system down. I'd like to hear other people's opinions on the situation, though. So, what are your thoughts on the Olympic transport policies and how do you think they've affected the economy?

Thanks for reading guys, stay tuned.

Sam. (@TutorEconomics)

Market Failure (Microeconomics)

Market failure is what occurs when the free market economy is left to run itself and resources are allocated inefficiently and not used correctly. For a market to be successful, it must be efficient.A few examples of market failure are the overconsumption of alcohol and tobacco or the underconsumption of health and education. These are examples of market failure because they occur when the economy is left to the free market mechanism and resources aren't being used efficiently or correctly.

Efficiency in an economy can be broken down into two different types: production efficiency and allocative efficiency.

Productive efficiency is achieved when everything that is produced is produced using the least amount of scarce resources. In other words, any point on the PPC curve (Refer to this post on the blog for more about PPC curves). If goods aren't being produced using the least amount of scarce resources then it is said to be productively inefficient and the market's failing.

Allocative efficiency is achieved when customer satisfaction in a market is maximised. So, the quantity supplied must be equal to the quantity demanded - in other words the market must be functioning at the equilibrium position for the market to be allocatively efficient.

There are many causes of this market failure, which will be discussed further in later posts, so stay tuned. Thanks.