Question

Describe the factor markets under perfect and imperfect competition and determine how strategies on price and quantity can maximize profits.

Answer 1

Market is a mechanism where a buyer and a seller meet to exchange ( for economic purpose—for a price) goods and services . However market can be divided into goods (and services ) market and factor market where factors of production are bought and sold.

Market is also divided on the basis of competition—perfect competition and imperfect competition. Perfect competition is characterised by large number of buyers and sellers buying and selling goods that are perfect substitutes for one another. It is also a form where firms are free to enter the industry and start up the business or in case they want to exit for reasons like losses they are allowed to leave the industry.

In case of resources or factors of production under perfect competition – the factor market is characterised by free to move feature—meaning-the factors of production can enter or quit the industry according to their convenience or in their own self interest—they can freely switch from one use to another according to their own interest—hence like the firms the factor inputs are also ‘free’ to enter or leave the industry.

This freedom of entry and exit in effect allows for forms to earn ‘normal profits’ in the long run. For example, if in a given time period ( called short run) firms under perfect competition are making ‘abnormal or more than normal profits’ it would attract other firms to enter the industry—as a result output expands profits fall and ultimately firms end earning normal profits in the long run.

On the other hand , in case of losses faced by the industry as a whole, some firms that are unable to meet their fixed and variable costs leave the industry, output contracts and firms end up earning normal profits in the long run.

Profits , in the short run can be can be maximised by two methods propagated ; 1. The Total Revenue –Total Cost approach, where all costs are considered and profits are maximised where the gap between the total costs (including fixed and variable) and total revenue is more.

2. However , the above approach was criticised because of not considering additional costs—hence the marginal cost—marginal revenue approach was advocated that gave out two important rules for firms to maximise profits : 1. MC = MR   2. MC curve cuts MR from below.

The above rules can be understood in the following way—a firm , if its incurring losses in the short run has to decide to produce or not— if the losses are short loved it will soon end up making profits but if they are there to stay then the firm is better off leaving the industry.

Hence the firm should produce only if the price of its product = the sales revenue (from selling the good) -- P = > AR

At the same time its cost of production especially the marginal ( or additional cost incurred in producing one more unit of a commodity) =    its marginal revenue--- MC = MR

A third point to be noted is that the producer should produce as long as the marginal cost of production is less than marginal revenue received from selling one more unit of the good. If the marginal cost were to exceed the marginal revenue then the producer is not maximising profits—

MC < MR for profit maximisation to occur .

Under imperfect competition –the market is characterised by firms selling products that are close substitutes not perfect substitutes to one another. Entry of firms is restricted to a great extent though under monopolistic competition it is fairly free.

The firm will maximise profits when its MC = MR and MC is below MR at the profit maximising level of output since a higher MC could mean that allocative efficiency is not achieved. In the long run a firm under imperfect competition ids better off operating at minimum costs of production called –economies of scale or lower per unit costs.

However , there is a distinction made in case of factor market under imperfect competition---the marginal revenue or MR need not necessarily be equal to the value of MR or the marginal revenue. If the factor input is getting paid (VMP or value of marginal product is less than the Marginal revenue—MR—then such an imperfection could lead to exploitation since the producer is enjoying profits (MR) at lower costs—(VMP).

Imperfect Competition features lack of free mobility of resources as well as imperfect or inaccurate knowledge about the prevailing market conditions – hence the resources may not be able to move –or enter and exit the industry freely.