Basic Market Structure and Perfect Competition

Discussion on “So What’s New? Is the “New Economy” really different from the old one?”  (Slate Magazine, Aug. 22, 2000)

 Summary

This article begins by comically comparing the economic model of supply and demand, with the Church and its use of the crucifix. It prefaces the argument by explaining the concepts of a market in equilibrium, as well as identifying other factors that affect the supply and demand model, such as marginal cost and the likeliness that it will eventually be equal to the price of a good as the market reaches equilibrium.

The author, Michael Kinsley, then explains that he has two concerns about the design of the model: 1. That marginal cost must be rising, and 2. That marginal cost must always be higher than average cost in order for a firm to cover all costs. He explains that in today’s economy, marginal costs are lower than average costs. He uses airline tickets as an example, saying that low priced tickets are used to cover the marginal costs, while identical tickets that are higher in price are covering all the other costs associated with operating the flight.

Kinsley explains that the basic concepts of supply, demand, and equilibrium do exist, but in today’s economy, there is no one making sure that market equilibrium is reached. This is what is causing the system to skew, and what is causing average costs to soar above marginal costs in many different markets. He identifies that in this day in age, marginal costs are not only not rising, some are in fact declining. As average costs and prices soar, marginal costs remain somewhat unaffected.

 Commentary

This article is slightly confusing (I’ve been talking myself in circles in my head!), because when we first learned of the supply curve, it was defined as amount that suppliers are willing to sell at a given point.  If a supplier can make more money per unit, the opportunity cost of producing an extra unit is greater than the gained utility of not producing the extra unit.  This is what makes the supply curve bend upward.

Understanding, though, that this assumes that marginal costs stays the same, the idea of decreasing marginal cost (due to economies of scale or other factors) adds complexity to the model.  Were marginal costs to stay the same the entire time, the increase in price would add an increasing amount of profits every time the price is raised.  Taking diminishing marginal cost into consideration, as price increases, units also increase, and as units increase, marginal costs decrease.  Thus, profits increase more in the second scenario than the first.  Suppliers are more willing to sell at a higher price point, and as an added bonus, the lower costs create more profits.  Thus, the curve still slants upward.

The problem with this model happens when price, not quantity, becomes the dependent variable.  At a higher number of units, a firm is willing to sell each individual unit for less money because the average cost per unit decreases as quantity increases.  Thus, a firm can still make a larger profit by charging less for each individual unit.

 Real World Application

An additional real-world application of the perfectly competitive market is in the fresh produce market. Traditionally known as the “classic case” of perfect competition, the fresh produce market was once characterized by a virtually unlimited number of producers selling identical goods to “large numbers of local and regional retail grocery chains” at market equilibrium prices. However, as the food industry (and the fresh produce market) have evolved over recent decades, the market has consolidated considerably with fewer, larger buyers mostly replacing the traditional local and regional grocery chains. As “value-oriented retailers,” such as Wal-Mart, and “upscale specialty stores,” such as Trader Joe’s and Whole Foods, have come to dominate the food market, most fresh produce is purchased directly from the producer by the retailer. In this market structure, producers are no longer perceived to be selling identical goods as specialty stores and value-oriented chains claim to be selling produce of varying quality. In addition, the transactions between producers and retailers now often include more than just the price of the produce. In today’s market, additional components are frequently included in fresh produce transactions, including “off-invoice fees” (rebates, discounts, and promotional fees), pre-negotiated volume commitments, and required “third-party food safety certification.” These additional components effectively limit entry into the fresh produce market, which is dominated by the mega retailers, violating the criteria of a perfectly competitive market. Once considered the best example of a perfectly competitive market, the fresh produce market has become far less competitive with the emergence of a few powerful retail chains that have altered the perception of seemingly identical producers and imposed restrictions on the entry of producers into the market.

Posted by Emma, Trevor, Elizabeth and Kristoff (Section 1)

Resources:

Dr. Roberta L. Cook. “Supermarket Challenges and Opportunities for Fresh Fruit and Vegetable Producers and Shippers: Lessons from the US Experience .” University of California, Davis. 24 May 2004. http://www.agmrc.org/media/cms/supermarketchallenges_01985EE36887A.pdf)

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