Short Response Questions – pg. 104

With the help of a diagram, explain how it is possible for a firm in perfect competition to earn abnormal profits in the short run.

The short run is the period of time in which the plant size of the firm is fixed, and firms are unable to enter or exit the industry. In a perfectly competitive market, firms are price takers, meaning that they must accept the market price that occurs naturally depending on demand and supply. If a firm is earning abnormal profits in the short run, it means that they are more than covering their total costs, including the opportunity costs. Where MC=MR, the quantity produced by the firm is maximized. At q, the average cost is C and the average revenue is P, meaning that the average cost is less than the average revenue, so the firm is earning profit on each unit that they produce. The amount of abnormal profit is the shaded rectangle on the graph. Earning abnormal profits is only possible in the short run because in the long run, firms can enter or exit the industry. The reason they would want to enter is because they realize that firms in that industry are earning abnormal profits, and are eager to earn abnormal profits for themselves. If firms enter or exit, there is a shift in the industry's supply curve which would cause the firm's price to decrease, eliminating its abnormal profits. Since the short run is the only time when firms are incapable of exiting or entering the industry, it is the only period of time in which firms may earn abnormal profits.

With the help of a diagram, explain how it is impossible for a firm in perfect competition to earn abnormal profits in the long run.

The long run is the period of time in which all factors of production are variable, but the state of technology is fixed. In the long run, firms in perfect competition will make normal profits because even if the firm is earning abnormal losses or profits in the short run, the industry will always adjust in the long run until the industry is in equilibrium. Because an industry will always reach equilibrium in the long run, it is impossible for a firm in perfect competition to earn abnormal profits in the long run. Abnormal profit only occurs if the firm's average cost is less than the firm's average revenue, which is impossible in the long run. The reason why firms in perfect competition will always earn normal profits in the long run is because if a firm is earning abnormal profits or losses, the industry will "correct" that with firms entering or leaving the industry until a normal profit situation is reached. The reason why firms would enter the industry is since there is perfect knowledge and no barriers to entry, firms outside of the industry that could also produce the good will be attracted by the chance to make abnormal profits. After a number of firms have entered the industry, the supply curve will start to shift to the right, which causes the price to fall, since there is an indirect relationship between quantity supplied and price. Because the firms are price-takers, the price that they can charge will start to fall and their demand curves will start to shift downwards. So, any abnormal profits they were earning will be eliminated as the price decreases until the industry eventually reaches equilibrium.

Explain whether or not a firm in perfect competition earning abnormal profits is productively and allocatively efficient.

If a firm is earning abnormal profits it is not productively efficient, however it may still be allocatively efficient. A firm is most efficient if it produces at the point where MC= minimum AC. A firm is productively efficient if it uses its resources to its maximum efficiency by producing its product at the lowest possible average cost, so where P= minimum AC. If a firm in perfect competition is earning abnormal profits, it means that they are producing above the minimum AC, hence P is not equal to the minimum AC, so it is not productively efficient. In order for the firm to be productively efficient, the quantity it produces would have to decrease until the price is equal to the minimum average total cost. Firms are allocatively efficient if they are producing the optimal mix of goods and services that the society needs and demands. The price of a product sends a signal from the consumers to the producers about how much of the product is demanded. If the price is higher than the marginal cost, it signals that more output is demanded by consumers, and if the price is lower than marginal cost, it is a signal from consumers that less output is desired. If a firm responds to these signals and are hence allocatively efficient, that means there is no under or over-allocation of resources towards a good. So, a firm in perfect competition earning abnormal profits can be allocatively efficient, but it is not productively efficient.

Commentary 1

Price-floor plan to counter cheap booze

Most of the time in a free market economy, an equilibrium price occurs naturally based on the supply and demand of the product, which leads to the greatest total welfare possible for producers and consumers. Supply is the willingness and ability of producers to produce a quantity of a good at a given price in a given time period. Demand is the quantity of a good that consumers are willing and able to purchase at a given price in a given time period. Equilibrium is where the supply and demand curve meet on a graph. The free market does not always, however, lead to the most optimal outcomes for society in general. If that is the case, the government will often intervene in the market by controlling the price of the product to adjust the outcome.

One way of controlling price is by setting a minimum price, known as a price floor, which is set above the equilibrium price. This forbids producers from selling their product at a price lower than the minimum price implemented by the government. In an article about a situation in Australia, the Government's National Preventative Health Taskforce is putting a price floor on alcoholic beverages. There are different reasons why the government might consider implementing price floors; it could for instance be to try to raise incomes for producers of goods and services that are important for society. In this case, though, the government is controlling the price due to health reasons. Because the price of alcoholic beverages in Australia is so low, the quantity demanded is very high, since according to the law of demand, there exists an inverse relationship between quantity demanded and price. Since the price of alcohol was incredibly low, it created a culture in which being drunk was considered normal, which is obviously not healthy for society.

At P_e the total economic welfare is maximized, meaning there is no inefficiency. However, the social welfare is not maximized, considering that there is lots of alcoholism. The price floor will indeed decrease the quantity demanded, but this does not happen without consequences. If the price of a good is forced above equilibrium price, then the quantity supplied increases according to the law of supply, which states that there exists a direct relationship between quantity supplied and price. So, the quantity demanded decreases and the quantity supplied increases, meaning that there is excess supply, known as a surplus.

If there is a surplus of a product, then that means that the market is inefficient, because resources will be over-allocated to alcohol, so society is not getting the most out of its resources. Another problem with a price floor is that it may lead to a "black market" for booze where it is sold at illegal, low prices, since the market price is below the legal price. For this reason, a price floor may make matters worse. A better solution to this problem would be for the government to intervene by placing a specific tax on all alcoholic beverages. On Graph 2, one can see that a tax causes the supply curve to shift to the left, which creates a new equilibrium. Because the quantity supplied and the quantity demanded decreases, the market falls in size from one producing Q_e units to one producing Q₁ units. A tax will always result in a dead weight loss (the purple triangle on the graph), which is the net loss of consumer and producer surplus that occurs when a market is in disequilibrium. However, the amount of dead weight loss that would occur if the government placed a tax on alcoholic beverages would be relatively small, considering that the price elasticity of demand for alcohol is relatively inelastic.

Price elasticity of demand is a measure of how much the demand for a product changes when there is a change in the consumer's income. If PED is inelastic, it means that consumers are relatively unresponsive to a change in price. In this case, the consumption of alcoholic beverages will decrease by a proportionally smaller amount than the change in price, because it is a good that is relatively addictive and it does not have any substitutes that consumers can replace it with. For this reason, the dead weight loss would be relatively small, so the total welfare for the community would increase since there will be fewer drunks.

Although the tax creates dead weight loss, it might actually benefit society because the total revenue gained by the government (illustrated on the graph as the turquoise rectangle) can be used to, for instance, fund campaigns against drinking alcohol. If the government spends the revenue from the tax on increasing the awareness of the dangers of alcohol, then that would be a more effective way of reducing the consumption of alcohol, as opposed to setting a price floor.