Question

Explain how in perfectly competitive markets, profit seeking can be a good thing for the economy as a whole. (Hint: specifically think of the long run equilibrium adjustment process and outcome)

Explain how in a monopoly market, profit seeking is a bad thing for the economy as a whole.

Answer 1

Perfect competition is a type of market structure where there are many buyers and sellers of the good. All the sellers produce homogenous goods. Since they sell homogeneous goods and there are so many sellers and buyers, no single buyer or seller has any market power to change the price and therefore they are price takers. Prices in this market are decided by market forces. Thus, in perfect competition, Price = average revenue = marginal revenue.

The profit-maximizing condition of a firm is at the point where the marginal revenue = marginal cost. Marginal revenue is the additional revenue generated from an extra unit of output sold. Marginal cost is the additional cost incurred from an extra unit of output produced. If MR>MC, the firm will find it profitable to increase the output level to the point where MR=MC. If MC>MR then the firm will find it profitable to decrease the output to the level where MR=MC.

In perfect competition equilibrium price and output are determined at the point where the marginal cost curve intersects the demand curve or where MC = AR (aggregate revenue or demand curve)

We know that in perfect competition there is free entry and exit of the firms. Suppose there are two industries A and B. Initially suppose that industry A is earning economic profits, the firms in industry B will find it attractive to leave industry B and enter industry A for earning profits. Now, what happens is that when some firms exit from B and join A, the supply curve of A will increase and that will lead to lower prices and lower profits. On the other hand, when few firms from B left, the supply curve of B decreased and prices increased which led to higher profits. Now, the firms will keep moving from one industry to another until both the firms earn zero economic profit. Thus, in the long run, in a perfectly competitive market, firms earn zero economic profit.

In the long run, a perfectly competitive firm earns zero economic profit, thus it is good for the economy as a whole as the consumers are not exploited by high prices and lesser output, and there is efficiency in the output and price determination under perfect competition.

A monopoly is a type of market structure where there is only one seller of the good in the market. Since there is only one seller, he has full control over the prices to be charged and output to be sold in the market.

Since a monopolist is a price maker, he charges price higher than charged in the perfect competition and supply lesser goods than by the perfect competition. The profit-maximizing level of output of the monopolist is where the MC (marginal cost) = MR (marginal revenue).

In the long run, a monopolist maximizes its profit by producing lesser output than the long run perfect competition output and charges a price that is greater than long-run perfect competition price and thus earns a supernormal profit.

The long-run output and price determination is not efficient and it exploits the consumers by charging a higher price and supplying lesser goods. Thus, in the monopoly market profit-seeking is bad for the economy as a whole as it exploits the customers by charging higher prices and earns supernormal profits in the long run.