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Perfect competition and social welfare

Explain why in competitive markets there can be profit or producer surplus in the short run but not the long run. Include the idea of "economic rent" for exceptionally productive inputs. Then imagine a firm with the same cost structure but in each of the four very distinct market structures: (1) Purely Competitive, (2) Monopolistically Competitive, (3) Oligopoly, and (4) Monopoly. Using the concepts of consumer surplus and producer surplus, explain the long run outcome in each market structure and how consumer surplus, producer surplus and dead weight loss changes.

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In a perfectly competitive market, firms are making a normal profit (zero profit) in the long run. In this situation, firms are price takers, ie they have to take price as decided by the market. Therefore, the market price is also equal to each firm demand curve. Each firm will make production decision based on their cost structure. Specifically, they will produce at a point when their marginal cost (MC) crosses the demand curve (market price). If firms in a competitive market are making super-normal profit or positive profit, new firms will enter the market because in a perfect competition, there is no barrier to entry. As a results of new entrants into the market, market supply will increase and eventually the market equilibrium price will go down. As the price goes down, firms who are initially making positive profits are now only making zero profit. That is market price will eventually equal to their average cost. ...

Solution Summary

Firms in a perfect competition market are able to make positive profit only in the short run. In the long run, there will be new entrants to bring the market price down and firms profits are eroded to zero as their average cost is equal to market price. In a competitive market, consumer surplus is maximized as producer surplus and deadweight loss are eroded.