Question

1. a. Explain why the long-run product price for a perfectly competitive firm will equal its minimum average total cost.

b. How does the “invisible hand” work in a competitive market system?

c. What is the concept of creative destruction? Describe two industry examples and how it has worked over time.

d. What economic conditions are necessary to achieve productive and allocative efficiency under pure competition?

Answer 1

a)A perectky competitive firm will charge a price equal to the minimum of its average cost of production, because perfect competition drives the price down to the zero profit level. (If price is above average costs then economic profits are being made. The economic profits will attract more firms in to this easy to get in to industry. More firms will shift the market supply curve to the right, which will drive down the market price. The market price will continue to fall until it is just equal to the minimum of the average total cost curve.) At this point, economic profits are zero, which means that firms in this industry are making a normal rate of return; a return comparable to similar industries.

b) The invisible hand is a concept that – even without any observable intervention – free markets will determine an equilibrium in the supply and demand for goods.The invisible hand means that by following their self-interest – consumers and firms can create an efficient allocation of resources for the whole of society.For most goods and services, there is no need for government regulation and price controls. The ‘invisible hand’ of market forces will ensure the optimal price and output.Agents pursuing self-interest can contribute towards societies well-being – even if they don’t mean to.If owners of capital increase in wealth – there can be a trickle-down effect to benefit everyone in society.Private business will follow their profit motive to find the most efficient use of investment funds.
Free trade is beneficial. Free trade enables firms to specialise in goods where they have a comparative advantage. Invisible hand refers to the "self regulating" market that controls profits, products and prices.The concept explains that an individual decision in a market economy to benefit them will actually make the economy better off as a whole.

c) Creative destruction refers to the process by which old industries or technologies are replaced by newer ones.As described by economist Joseph Schumpeter, creative destruction refers to the way in which technological or other innovations may create new products or new production methods, in some cases causing whole industries to disappear only to be replaced by new ones.

Examples of creative destruction in history include Henry Ford's assembly line and how it revolutionized the automobile manufacturing industry. However, it also displaced older markets and forced many laborers out of work. Netflix is one of the modern examples of creative destruction, having overthrown disc rental and traditional media industries—now being known as the “Netflix effect” and being “Netflixed.

d) Social economic efficiency exists when the goods and services that society desires are produced and consumed with no waste from inefficiency in either production or consumption. To reach this goal, two efficiency conditions must be fulfilled: productive efficiency and allocative efficiency. Productive efficiency exists when suppliers produce goods and services at the lowest possible total cost to society. Allocative efficiency requires businesses to supply the optimal amounts of all goods and services demanded by society, and, these units must be rationed to individuals who place the highest value on consuming them. P=MC. Markets in perfectly competitive equilibrium achieve social economic efficiency because, at the intersection of demand and supply curves, conditions for both productive efficiency and allocative efficiency are met. At the competitive market clearing price, buyers and sellers engage in voluntary exchange that maximizes social surplus.

Allocative efficiency:

• In both the short and long run we find that price is equal to marginal cost (P=MC) and thus allocative efficiency is achieved.
• At the ruling price, consumer and producer surplus are maximised.
• No one can be made better off without making some other agent at least as worse off – i.e. we achieve a Pareto optimum allocation of resources.

Productive efficiency:

• Productive efficiency occurs when the equilibrium output is supplied at minimum average cost.
• This is attained in the long run for a competitive market.
• Firms with high unit costs may not be able to justify remaining in the industry as the market price is driven down by the forces of competition