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Do we even *want* perfect competition?

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Wheylous posted on Fri, Jul 27 2012 10:54 PM

In perfect competition, the marginal firm makes no profit. But depending on how seriously you take the underlying assumptions of PC, doesn't perfect information imply that no firms will have any profit?

Why do I say that?

Well, the marginal firm makes no profit - that's known. It is possible that there are other firms that have better production structures than the marginal firm, and so they do earn profit. But can these firms really exist under perfect competition? If people are profit-maximizing and there is perfect information, then all firms would adopt the most efficient production pathway and all firms would be marginal. Hence, no profit for any firm.

And if there are no profits, there is no money for reinvestment and capital accumulation, which are some of the main drivers of improvement.

Am I just taking introductory Micro too seriously in its assumptions? (even basic understanding of better micro shows that basic neoclassical theory of the firm essentially kills the role of the entrepreneur.)

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Answered (Not Verified) Neodoxy replied on Fri, Jul 27 2012 11:24 PM
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Perfect competition is dumb, it's really practically useless. In real life a monopoly could well be more beneficial to the consumer than perfect competition.

Anyway yeah you have to be right if we assume perfect information.

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Beautiful.

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Anenome replied on Sat, Jul 28 2012 12:49 AM

Perfect competition would seek equilibrium in the same way that the ocean is always seeking the lowest point. In practice, neither can ever achieve it and continual sloshing results. In the case of competition, this would mean continual productive competition.

Survivng in this environment is difficult, businesses must try hard to continually improve and stay on top of their game and their product. They don't like that, which is why they've historically turned to ally with the state to make it harder for other companies to challenge them, thus cementing their position.

And there's never 'perfect information' as such would be tantamount to omniscience. That's a whole problem unto itself.

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Anenome,

What Wheylous is talking about is the Neo-Classical school's conception of perfect competition, which is almost an unrealizable state of affairs.

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I suggest reading Steve Keen's Debunking Economics; he shows -- and the argument is not originally his -- that firms in the model of perfect competition are actually making a loss.  Keen's book is a good critical overview of neoclassical micro price theory.

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Jonathan, my problem is that I fear I'm attacking a strawman by critiquing the Introductory Micro ideas I've learned - surely they are more sophisticated later on? Shouldn't I wait to read critiques of it after I actually understand what neoclassical micro is at its best?

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Wheylous:

In perfect competition, the marginal firm makes no profit. But depending on how seriously you take the underlying assumptions of PC, doesn't perfect information imply that no firms will have any profit?

Why do I say that?

Well, the marginal firm makes no profit - that's known. It is possible that there are other firms that have better production structures than the marginal firm, and so they do earn profit. But can these firms really exist under perfect competition? If people are profit-maximizing and there is perfect information, then all firms would adopt the most efficient production pathway and all firms would be marginal. Hence, no profit for any firm.

And if there are no profits, there is no money for reinvestment and capital accumulation, which are some of the main drivers of improvement.

Am I just taking introductory Micro too seriously in its assumptions? (even basic understanding of better micro shows that basic neoclassical theory of the firm essentially kills the role of the entrepreneur.)

My understanding is that no firm makes an economic profit, which is income above their opportunity costs, but they do earn accounting profits which can be reinvested into the business.

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Rcder replied on Sat, Jul 28 2012 10:57 AM

In perfect competition, the marginal firm makes no profit.

Under pure competition no firm in the industry makes a profit.

But depending on how seriously you take the underlying assumptions of PC, doesn't perfect information imply that no firms will have any profit?

Pure competition does not necessarily require symmetrical information.  The primary requirment for pure competition to prevail is that each firm in the industry is a "price-taker", meaning it cannot influence the prevailing market price for its good such that its individual demand curve is perfectly elastic.

Well, the marginal firm makes no profit - that's known.

I think you're mixing up Rothbard's theory of the firm with perfect competition; under Rothbard's conception of the firm the marginal firm would have a rent of decision making ability close, but not equal, to zero.  Under perfect competition, in a state of equilibrium there would no marginal or supramarginal firms; every firm would have a profit rate of zero.  There are hypothetical scenarios where firms can have a demand curve above the trough of their average total cost curve, but this profit is quickly eliminated through new firms entering the industry and shifting the aggregate supply curve to the right.

It is possible that there are other firms that have better production structures than the marginal firm, and so they do earn profit.

This is not the case under a scenario of perfect competition.  Every firm is operating at a state of maximum productive efficiency and allocative efficiency, or where price is equivalent to average total cost and marginal cost (P=ATC=MC). 

And if there are no profits, there is no money for reinvestment and capital accumulation, which are some of the main drivers of improvement.

Sometimes this is a criticism of perfect competition and sometimes it isn't.  Some economists view perfect competition as a positive analysis of markets as they actually exist in the real world, in which case your criticism would most likely be viewed as a meaningless ethical pronouncement, while others view it as a normative standard which real world markets should be evaluated against, in which case this point would carry more water.

 

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Rcder replied on Sat, Jul 28 2012 11:04 AM

My understanding is that no firm makes an economic profit, which is income above their opportunity costs, but they do earn accounting profits which can be reinvested into the business.

A firm earns an economic profit if its rate of profit is higher than the natural rate of profit (natural rate of interest).  A firm can earn an accounting profit while suffering an economic loss; for example, if the prevailing natural rate of interest is 5% per annum and the firm earns 3%, then it's making an accounting profit of 3% but is laboring under an economic loss of -2%.  Under perfect competition the firm does not earn an accounting profit or an economic profit (all revenue is absorbed by payments to the factors of production sans time). 

In Man, Economy, and State, Rothbard notes that price does indeed equal average total cost in a state of equilibrium if you consider interest to capitalists as a cost to the firm.  Perfect competition does not make this assumption. 

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Rcder replied on Sat, Jul 28 2012 11:06 AM

What Wheylous is talking about is the Neo-Classical school's conception of perfect competition, which is almost an unrealizable state of affairs.

I can't think of a situtation where it would ever be realizable, the most obvious reason being that every firm, however small its ouput, influences the market supply curve; therefore, its individual demand curve will always be downward-sloping. 

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A firm earns an economic profit if its rate of profit is higher than the natural rate of profit (natural rate of interest).  A firm can earn an accounting profit while suffering an economic loss; for example, if the prevailing natural rate of interest is 5% per annum and the firm earns 3%, then it's making an accounting profit of 3% but is laboring under an economic loss of -2%.  Under perfect competition the firm does not earn an accounting profit or an economic profit (all revenue is absorbed by payments to the factors of production sans time).

I had wondered what the terms were for those two notions of profit. Is economic profit the same thing that Mises means by entrepreneurial profit?

"The limits of my language mean the limits of my world." ~ Ludwig Wittgenstein
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Rcder replied on Sat, Jul 28 2012 12:13 PM

I had wondered what the terms were for those two notions of profit. Is economic profit the same thing that Mises means by entrepreneurial profit?

They do indeed mean the same thing.

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This is not the case under a scenario of perfect competition.  Every firm is operating at a state of maximum productive efficiency and allocative efficiency, or where price is equivalent to average total cost and marginal cost (P=ATC=MC).

Just because price equals act and mc doesn't mean that it's using the optimal resources. If a firm moves construction materials by donkey, for example, it will likely have an mc farther to the right.

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Rcder replied on Sat, Jul 28 2012 7:18 PM

Just because price equals act and mc doesn't mean that it's using the optimal resources. If a firm moves construction materials by donkey, for example, it will likely have an mc farther to the right.

"Productive efficiency" is producing the most of a given product considering a static number of resources, or correspondingly, producing a good at the lowest possible cost, while "allocative efficiency" is producing the quantity of a good demanded by society at the time.  This is often used as a normative criticism of existing market structures, especially conditions of monopolistic competition where price is above marginal cost and the demand curve is tangent to the average total cost curve at a point above minimum average total cost (the problem of excess capacity).  Both of these criterion are applied in a case where the market is in a state of equilibrium, so if transportation with donkeys were the most economical choice for the firm then that's what would be used.

It's important to note that I am in fact an Austrian (sometimes that doesn't come across in these posts), but in this case I'm responding to you as a "mainstream" economist. 

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