Homework-induced epiphany…

…possibly laced with a good dose of Dunning-Kruger, so I’d appreciate it if people more edumacated in economics would point out if I’m missing something or drawing ignorant conclusions.

Anyway, I just finished slogging through the math-heavy section of my economics textbook that dealt with different forms of economies, most notably “pure competition”, “monopolistic competition”, “oligarchy”, and “pure monopoly”. This being the textbook I previously described, it did not contain any human beings and stressed economic efficiency a lot. And of course there’s only one system that produces both allocative and productive efficiency (meaning that resources in the system are allocated in the most “desirable” way, and that everything is produced in the cheapest possible way): the pure competition.

Anyway, so here’s how that’s supposed to look in graph form:

on the left is what an individual company’s curve would look like, on the right is the graph for the entire industry. Now, I’m mostly interested in the right left chart. that dot saying P=MC=minimum ATC is the point at which production supposedly occurs in a company in a purely competitive economy. p=price of each unit of product, MC=marginal cost (i.e. the cost of producing and selling one more unit), ATC = average total (i.e. variable and fixed) cost cost, (i.e. average cost of each unit sold). so the point at which each of these companies produces is the point at which the price for each unit sold is exactly the same as the cost of producing it.

Think about this.

This means this company is making zero economic profit. It’s not supposed to make any, in the long term. If it did, that would mean it is producing at a point on the demand-curve above ATC, the difference being the profit. And you achieve efficiency only if you don’t produce above minimum ATC.

According to that model, profit is inefficient.

Now, the graph on the right claims that some profit is being made even with efficient production. That’s the orange part called “producer surplus”. How this producer surplus comes about out of a market made up by companies which all function like the one in the right chart, I don’t know, and that’s the part where I’d really love a real economist to step in an explain.

Anyway, back to the single company. The one that isn’t supposed to make any economic profit in the long-term. What human thought-process would make a person enter such a market, where businesses operate at zero economic profit? What person adds to their workload for no profit? Now, I can see that there’s a group-profit here. After all, things are being produced. And if you’re a laborer, then you’re getting paid, because your wage is part of the variable cost included in the ATC. But what’s in it for the individual entrepreneur? Wouldn’t it be more profitable to such a person to not go into business, and instead use that otherwise unprofitably invested time to, I don’t know, plant a vegetable garden to reduce food-costs instead?
The answer my textbook provides is about short-term fluctuations: sometimes demand for a product rises, which causes price to rise creating a short-term window of profitability. This is where more businesses enter the market, supply rises, and profit goes back down to non-profitable levels (for balance, sometimes demand shifts in the other direction and short-term losses result). But then what? The model seems to say that the companies then just go on blithely producing things at no profit (because shutting down is more expensive), but is that realistically really what would happen? A whole industry full of businesspeople not earning much of anything on their business, and being ok with that? I find that hard to believe. What seems to happen in the real world is that businesses attempt to prolong that small window of profitability for as long as possible. I can think of two common ways of doing this.

1)The window of profitability is created by an upward (or rightward on the graph) shift in demand. Creating a continuously shifting demand-curve would create a continuously open profitability window, even when more and more businesses enter the market or expand production capabilities to satisfy the demand. Thus, growth-economics and the never-ending race upwards until we run out of resources.

2)The window of profitability is profitable because the number of companies was sufficient for a lower demand, thus introducing a temporary shortage in producing businesses, and thus a price-spike. Businesses could attempt to keep that level by driving new businesses out of business, buying them, merging, etc. And once you’ve started that process, you have very little, AFAICT, that prevents that process from continuing past the original point and turning this “purely competitive” market into an oligopoly. Oligopolies, btw, are inefficient but very profitable.

So here’s two things. One, shouldn’t libertarians hate large profits, since they’re a blatant sign of economic inefficiency and a sign that the market isn’t working? And two, how exactly does a perfectly competitive market remain so, when there’s no rational motivation to create and maintain a business that makes no profit in the long-term?

I’m thinking an explanation of how the left chart leads to the right chart could probably answer those questions. But without that answer, it just doesn’t make any fucking sense.

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22 comments on “Homework-induced epiphany…

  1. David Marjanović says:

    I’m more ignorant than you.

    — What is MR (in the left chart)?

    — The right chart has an axis labeled “quantity” and a curve labeled “supply”. Uh… where’s the difference between “quantity of produced goods” and “supply of produced goods”? Surely not the state buying stuff up and destroying it to keep the supply low and the prices at a minimum?

    — Why does ATC rise with quantity above Q(f)?

    — Why does MC rise at all before the market is saturated and the costs of selling one more unit have to include the costs of shifting the demand curve to the right? And why does it only begin at a quantity well above the one where ATC starts?

    What gets me angry is that the axes have no scales. Only one point is indicated on each, so we don’t even know if the axes are proportional. For this reason, it doesn’t mean anything that one of the graphs is linear and the others are circle sectors, and the humble reader cannot distinguish these charts from the assertion that we’re on the right side of the Laffer curve.

    Now, I’m mostly interested in the right chart.

    Left. :-]

    According to that model, profit is inefficient.

    …which is precisely why fields where efficiency is of extreme importance, like education and healthcare, must not be left to for-profit enterprises.

    Somehow I think that’s the exact opposite of the point the authors wanted to make.

    How this producer surplus comes about out of a market made up by companies which all function like the one in the right chart, I don’t know, and that’s the part where I’d really love a real economist to step in an explain.

    Seconded.

    1)The window of profitability is created by an upward (or rightward on the graph) shift in demand. Creating a continuously shifting demand-curve would create a continuously open profitability window, even when more and more businesses enter the market or expand production capabilities to satisfy the demand. Thus, growth-economics and the never-ending race upwards until we run out of resources.

    That’s called capitalism.

    2)The window of profitability is profitable because the number of companies was sufficient for a lower demand, thus introducing a temporary shortage in producing businesses, and thus a price-spike. Businesses could attempt to keep that level by driving new businesses out of business, buying them, merging, etc. And once you’ve started that process, you have very little, AFAICT, that prevents that process from continuing past the original point and turning this “purely competitive” market into an oligopoly. Oligopolies, btw, are inefficient but very profitable.

    If the state does it, that’s called communism.

    In the West, the state acted and still acts as the guardian of competition, preventing mergers and breaking up monopolies. Supply thus cannot stay lower than demand, method 2 is out, and method 1 happens.

    In the East, the state had the monopoly on almost everything and did pretty much nothing to artificially increase demand even further, so method 2 happened. Resources weren’t wasted in such horrible amounts*, at the price of relative poverty — the state had the monopoly on apartments and everything.

    Looks like a Catch-22.

    * Except for prestige projects and the military, but I suppose that’s another story.

    One, shouldn’t libertarians hate large profits, since they’re a blatant sign of economic inefficiency and a sign that the market isn’t working?

    Yes.

    This has been today’s edition of Simple Questions, Simple Answers. See you tomorrow, same time, same channel!

    At best, they could say large profits are a sign of an immature market that the Invisible Hand hasn’t made grow up just yet.

    And two, how exactly does a perfectly competitive market remain so, when there’s no rational motivation to create and maintain a business that makes no profit in the long-term?

    Massive, heavy-handed state intervention to protect capitalism from itself. As I keep saying, the EU Commissioner for Competition is the mightiest force for capitalism in the world.

  2. Jadehawk says:

    What is MR (in the left chart)?

    MR=Marginal Revenue, i.e. the extra cash you get from selling one more unit of something. In this case, it’s identical to the price of something, meaning with each additional unit produced and sold, your revenue always rises by exactly the price of the additional unit.

    The right chart has an axis labeled “quantity” and a curve labeled “supply”. Uh… where’s the difference between “quantity of produced goods” and “supply of produced goods”? Surely not the state buying stuff up and destroying it to keep the supply low and the prices at a minimum?

    supply is a curve of which goods would be produced at which price, which at least in these simplistic models is determined by the number of suppliers willing and able to produce at a given price, which rises as the price rises, because not everybody has ideal conditions of production and can be the magic supplier who produces even at horrendously low prices.

    I’m not sure what your question is, though.

    Why does ATC rise with quantity above Q(f)?

    well, ATC always varies because it’s a combination between fixed costs like rent for your store/factory (which, if you divide it by the units produced, becomes smaller and smaller with each additional unit), and variable costs like wages, which at some point start becoming higher for each new unit produced (i.e. if you only have 2 espresso machines, each with 2 people working on it, adding another 2 people isn’t going to produce as much of a difference to how many cappucchinos you can produce in a day than adding the 2 employees to staff the 2nd espresso machine). So there’s one optimal point at which the total cost of production divided by the number of products sold is at a minimum.

    Why does MC rise at all before the market is saturated and the costs of selling one more unit have to include the costs of shifting the demand curve to the right? And why does it only begin at a quantity well above the one where ATC starts?

    marginal cost is the cost of producing something and doesn’t have anything to do with the demand curve. it’s simply how much more money you have to spend to produce one more thing, in terms of raw materials, labor, electricity to run your machinery, etc. IOW, the marginal cost of producing the 3rd unit is the total cost of 3 units minus the total cost of 2 units. so of course it’s going to raise, since it takes more resources for each additional unit. how many more resources, and how that’s offset by a smaller share of the fixed costs, is what determines how much MC rises (or falls, if you were underworking your employees, underusing your facilities severely, and weren’t able to buy raw materials in bulk until now)

  3. Jadehawk says:

    For this reason, it doesn’t mean anything that one of the graphs is linear and the others are circle sectors

    there are explanations for this in the book, but I wasn’t going to copy every graph in the chapter. anyway, it doesn’t really “mean” anything anyway. there’s no real-world data attached to these curves, they’re all theoretical models so far. so for all I know, they’re pulling it all outta their asses.

    which is precisely why fields where efficiency is of extreme importance, like education and healthcare, must not be left to for-profit enterprises.

    the thing with stuff like healthcare is that I really don’t think their demand curves look like the ones in these graphs (plus, there’s buttloads of positive externalities to consider, the existence of which was completely ignored in these chapters even though they were mentioned in a previous chapter).

    In fact, I’m pretty certain no real-world demand curves look like that, once you factor in human psychology and human physiology. which is why I’m really looking forward to more free time, when I can read up on behavioral economics. Maybe then there won’t be just models, but some actual empirical data to go with them…

  4. Paul says:

    And two, how exactly does a perfectly competitive market remain so, when there’s no rational motivation to create and maintain a business that makes no profit in the long-term?

    There is no such thing as a perfectly competitive market, and nobody actually in the business of business wants there to be one (only some of the people convinced to check R on their ballots without really understanding what’s going on really want a perfectly competitive market).

    I understand why you’re asking in this context, and this post is interesting, but this is a question that nobody really wants to answer in the first place. Although perhaps my US-centrism is showing, with David’s comment on the EU? Although from an ideological point of view, David’s response doesn’t really answer your question. If the Commissioner of Competition really can crack down to maintain a system as you’ve described, no reason is provided to keep those starting businesses from simply taking their ball home and playing John Galt.

  5. David Marjanović says:

    Thank you! I thought economies of scale are normally larger than the extra costs for resources, labor etc. for one more unit… turns out this was just another unexamined prejudice.

    so for all i know, they’re pulling it all outta their asses.

    That’s what I feared.

  6. David Marjanović says:

    *facepalm*

    I hypercorrected. That’s what happens when copying & pasting doesn’t work.

    *facepalm*

  7. Jadehawk says:

    There is no such thing as a perfectly competitive market, and nobody actually in the business of business wants there to be one

    yeah, I figure the people in the business of business actually want to be the owners/managers of a monopoly, or at least an oligopoly. The people regulating it, in a best-case scenario, want a weak oligopoly. No one seems to seriously want either a purely competitive market, or even a “monopolistic competition” (those aren’t supposed to be profitable either, even though they aren’t fully efficient. My textbook claims that the small losses of efficiency are made up for by the fact that MC produces more product variety than PC), even though the latter at least superficially resembles real capitalist markets, precisely because everyone seems to be very much in love with the concept of profitable businesses.

    Thank you! I thought economies of scale are normally larger than the extra costs for resources, labor etc. for one more unit… turns out this was just another unexamined prejudice.

    well no. the definition of “Economies of Scale” is, specifically, “reductions of ATC as the firm expands the size of a plant in the long run”. Marginal costs change on much smaller, much shorter scales. They change mostly because of under-use of existing resources on the downsloping part of the curve (not visible here), and because of the law of diminishing returns on the upsloping part.

  8. David Marjanović says:

    I see (…I think). :-)

    What is “monopolístic competition”?

  9. Paul says:

    Thank you! I thought economies of scale are normally larger than the extra costs for resources, labor etc. for one more unit… turns out this was just another unexamined prejudice.

    It’s generally accurate, just not germane to the models being shown. As Jadehawk said, they are looking on a much shorter scale when it comes to Marginal Cost. If you wanted to look at a plot that approximated real-life, it would be more of a saw-tooth that drove MC up as you produced more units, until it became cost effective to rehaul/build new facilities at which point MC would go back down a ways to take into account efficiency of scale, then start stepping up again.

    But then, your comparison to Laffer was apt. There is no real desire to fit the model to real-life (or to update models to actually resemble real life and teach that, since then high school econ would lead to a good bit of “hey, that’s not right” instead of some rote memorization of some dry and uninteresting models) and try to determine at what position the economy lies. Nobody cares about a perfectly efficient economy. The businesses want to maximize profit via Monopoly or Oligarchy. The Legislative and Executive Branches want to maximize donations by keeping the businesses happy. The Judicial is a bit of a wild-card, although not so much lately where they mostly seem interested in keeping the Executive happy.

    What is “monopolístic competition”?

    Monopolistic Competition. As far as I can tell, it has to do with branding. Think of shoe sales. Nike and Reebok aren’t in direct competition. They’re in the same market, but the prices of Nike shoes are set based on the Nike brand. They have to be aware of competitors offering similar products, but the products are not interchangeable and they have a monopoly on their brand.

    I could be getting that completely wrong. Send out the KG signal, maybe?

  10. Jadehawk says:

    I could be getting that completely wrong.

    no, that sounds pretty much right, AFAICT. And I was about to use NIKE in an explanation of monopilistic competition, too :-p

    anyway, I’d really be more interested in a ‘Tis Himself signal on this issue, but he’s gone sailing for the weekend.

  11. Paul says:

    Yeah, I was trying to remember his tag but couldn’t bring it up. Been awhile since I stopped by the tentacled blog.

  12. David Marjanović says:

    So monopolistic competition is just like niche differentiation in evolutionary ecology. :-) I keep underestimating Wikipedia on such things.

  13. Jadehawk says:

    isn’t it fascinating how much you can learn about economics when you study ecology? :-p

  14. David Marjanović says:

    Absolutely. :-)

    In particular evolutionary ecology: the question where biodiversity comes from, why it’s so high in general, why it is different in different places, how it is maintained… concepts like “the ghost of competition past”…

    I’m reminded of Lee Smolin’s “fecund universes” hypothesis, which he commented — retranslating from German, and from memory –: “Maybe the great geniuses that have explained the universe are Einstein, Bohr — and Darwin?”

  15. johannes says:

    If the state does it, that’s called communism.

    Actually, the Stalinists never claimed that their state-capitalist system was already communist; after all, consumer goods were still bought and sold as private property, not held in common. They considered communism their goal, and claimed that state-capitalism would somehow turn in to communism in the future(that’s why they called themselves communists), but they were patently unable to explain why, and how this would happen.

    Resources weren’t wasted in such horrible amounts(…)Except for prestige projects and the military, but I suppose that’s another story.

    The GDR actually used far more primary energy per capita than comparable Western European states, and rivalled the US or Canada in this respect, but, as the eastern bloc’s showcase economy, this probably can be filed under prestige projects.

    As I keep saying, the EU Commissioner for Competition is the mightiest force for capitalism in the world.

    Needless to say, something inspired by Teddy Roosevelt’s anti-trust laws is considered counterintuitive (to put it conservatively) by the German elites, who are collectivist and corporativist by nature and still consider the IG Fhtagn* an ideal. Eon and RWE are on a permanent quest to find loopholes in the EU’s anti-monopoly regulation.

    *http://en.wikipedia.org/wiki/IG_Farben

  16. David Marjanović says:

    What is primary energy?

    but they were patently unable to explain why, and how this would happen.

    Historical inevitability. *snark*

    IG Fhtagn

    X-D X-D X-D X-D X-D

    Eon and RWE are on a permanent quest to find loopholes in the EU’s anti-monopoly regulation.

    Don’t worry, as soon as the Commission looks the other way, EdF* will buy them both.

    Or has it already?

    * Electricité de France, owned by the French Republic.

  17. johannes says:

    What is primary energy

    See here:

    http://en.wikipedia.org/wiki/Primary_energy

  18. Jadehawk says:

    IG Fhtagn

    oh, that’s just made of win

  19. Jadehawk says:

    In the US, they have a similar issue with telecom companies. AT&T and Verizon are quickly becoming a hidden monopoly (meaning that they had to reshuffle assets between them to preserve the illusion of competition in places like ND after yet another merger).

    which is just fucking ridiculous, because A&T has been broken up before for exactly that reason

  20. David Marjanović says:

    What did I just say about underestimating Wikipedia? X-)

  21. Jadehawk says:

    well, if anyone still cares, I found the answer to one of the problems here. I’d completely overlooked the fact that in economics, the profit necessary for retaining the business-owner in that business is counted as a cost. So, the business owner is supposed to make a profit: exactly enough to make them not want to quit.

    which can be just about anything, since I’m not sure how one would measure that, in real life?

  22. Paul says:

    well, if anyone still cares, I found the answer to one of the problems here. I’d completely overlooked the fact that in economics, the profit necessary for retaining the business-owner in that business is counted as a cost.

    Just out of curiosity, how does that differ from the costs of paying normal employees? The cost of many employees cannot be directly packaged into “x% of revenue from y widget” any more than the salary that the business-owner chooses to take for him- or herself. If it is counted as a “cost”, then that would mean that the “profit” made is not truly profit (it is counteracted by the cost when paid to the owner).

    It’s just a question of how you structure your model. It isn’t “wrong”, unless we’re talking about fitting it to the real-life instantiations of the businesses. How do you model the need to post a profit to interest potential shareholders? The appearance of solvency to procure money to expand? Making sufficient profit to retain a board of directors? etc etc. Of course, I am pretty much formal economic-illiterate despite a quarter or two in college, so take whatever I say with a grain of salt.

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