Perfect Competition vs. Imperfect Competition

Firm behavior in competitive markets is probably one of the most fundamental subjects in economics. That is mainly due to the fact that most markets we encounter in reality are competitive, at least to a certain degree.

Competition is characterized by a multitude of firms offering the same (or a similar) good or service or a close substitute. In general it can be said that the more similar the goods or services are, the more competitive the markets will be. However, the competitiveness of a market is still highly dependent on firm behavior. For example, companies engaging in collusive behavior may result in a significant impediment to competition. For now, we will assume that firms do not engage in such activities.

As mentioned above, competitive markets may experience different degrees of competition. To explain the principle of competitiveness, it is useful to distinguish between two different market structures: perfect competition and imperfect competition.

Perfect competition

As the name suggests, perfect competition is considered the purest form of competition. For a market to be perfectly competitive, the following criteria need to be met:

• The goods that are sold need to be homogeneous. In other words, they need to be exactly the same and can thus be substituted at no cost.
• There must be no preferences between different sellers. For the customers it should not matter from which seller they buy their products.
• No actor should have the ability to affect the market price. That means, both buyers and sellers do not have any market power and can thus be considered price takers.

Looking at these criteria, it becomes apparent, that they will hardly ever be met in reality. Even so, an example that comes fairly close to perfect competition is the market for rice. There are thousands of buyers and sellers and the products are mostly identical. But it will never be perfectly competitive, as there will always be minor differences in products, preferences between sellers and so on.

However, at this point it is important to note that the idea behind perfect competition as a theoretical construct is to help explain various market mechanisms and economic behavior. So even though we may not find perfectly competitive markets in reality, the concept is still extremely relevant.

Imperfect competition

In contrast to perfect competition, imperfect competition is a fairly common market structure in practice. It is defined by the following characteristics:

• The goods that are sold are differentiated. That means, even though they mostly satisfy the same needs, there are minor differences that allow customers to distinguish the products from one another. 
• Due to the differentiated goods, customers develop preferences for some sellers. Thus, they are willing to spend more money on goods from specific sellers.
• As a result, the sellers may exert a certain degree of market power and charge a price premium. Hence, they can directly influence the market price to a limited degree and are no longer pure price takers.

An example of imperfect competition is the market for cereals. Just think about the cereal aisle at your local supermarket, you will find dozens of different cereals (Cap'n Crunch, Lucky Charms, Froot Loops, Apple Jacks, etc.). Out of those brand you probably have a favorite, like most people. However, if you think about it, those cereals are actually not that different. Ultimately, they all serve the exact same need; providing you with a tasty breakfast.

In a nutshell

Competitive markets are characterized by a multitude of firms offering the same (or a similar) good or service or close substitutes. They can either be perfectly competitive or imperfectly competitive. In perfectly competitive markets the goods are homogeneous, consumers have no preferences, and neither buyers nor sellers can influence the market price. Imperfectly competitive markets on the other hand are distinguished by differentiated products, consumer preferences, and as a result a certain degree of market power for sellers.

Decile funding - pros and cons

There's been quite a bit of reaction in the social media to the news that 'Poorly targeted' school decile funding may be dropped. It's not easy to make much of a case for anything in 140 character bursts, so I thought I'd take a bit more space to wonder if the case against decile funding isn't being oversold.

Here's some data, from the same article, which shows the percentage of students in different decile schools who are well below the national standard for maths (I gather you'd get the same picture if you looked at other subjects). What would you conclude from this chart?

You'd have to say that there is some at least rough and ready correlation between decile level and school performance. Performance worsens as you move down from decile 10 to decile 1 (other analyses have found the same pattern). You'd be inclined to keep a school's decile status in play as an explanatory factor, rather than junking it.

Since this is the picture after schools have had decile-related resourcing, you'd have to suspect that the relationship would have been even more pronounced pre-resourcing. You could, I suppose, make the argument that decile funding has been completely ineffective, and the relationship in the chart is the same pre and post decile-related funding, but that seems to me to be a big stretch to the rather unlikely counterfactual that funding levels make no difference at all to educational outcomes. There's an even more unlikely possibility, that decile funding was counterproductive, and that the decile/performance relationship would have been less pronounced without greater funding to lower decile schools, but I can't see how that would work, certainly not at any systemic national level. So you'd be inclined to believe decile funding has had some positive impact.

But self-evidently, the decile-related funding has not completely equalled out school performance. One part of the answer is that the link between a school's socio-economic profile as summarised by its decile classification and a school's performance isn't 100%, and it's unlikely that it ever could have been. So you'd be sympathetic to arguments that would tweak or supplement the decile funding system, though not to wholesale junking of the approach.

Another part of the answer, though, is likely variation in teaching quality at different schools. In the chart, there's a clear pattern of poorly performing outliers at every decile level. It's unlikely that all of that pattern is down to slippage in the relationship between decile level and educational outcomes, though some of it will be. For example, that outlier decile 2 school, the worst in the chart, could well be facing tougher challenges than most of the decile 1 schools, either because it got mismeasured in the decile process or because the things that matter outside the decile criteria weigh especially heavily on it (equally there could be schools that have been coasting, and their performance reflected an easier catchment challenge in reality than the decile ranking suggested). But some of it, as in most endeavours in life, is likely to be down to variations in the quality of the provider.

Either way, you'd be inclined to hone in on those outliers from two perspectives. One is that, if there is indeed something missing from the decile approach, and there seems to be, then these outlier schools are the most likely place to find it. And the other is that if they're just bad schools, you'd want to sort them out.

Profit Maximization

In economics it is often assumed that companies try to maximize profit. That is, they try to maximize revenue while at the same time minimizing costs. In order to do that, firms need to look "at the margin". That means, they have to keep an eye on changes in revenue (i.e. marginal revenue) and changes in costs (i.e. marginal costs) for every additional unit sold.

To introduce the principle of profit maximization, it seems reasonable to focus on firms in a competitive market first. However, as we will see later on, this principle can be applied to most firms in various market situations (monopoly, oligopoly, etc.).

As mentioned above, to maximize profits, a firm needs to examine changes in revenue and costs for every additional unit sold. As long as the resulting increase in revenue is larger than the increase in costs, total profit can still be raised by producing more. This will hold true until marginal revenue (MR) equals marginal cost (MC). In other words, a profit maximizing firm will produce until MR=MC.

This can be illustrated by looking at a simple diagram that shows the relations between output and costs or revenue respectively. Though, before we can do this, we need to find out what the relevant marginal cost and marginal revenue curves look like.

Marginal Revenue

Computing marginal revenue in a competitive market is actually pretty simple. In fact, it is always equal to the price of the good or service sold.To explain this, we shall look at a characteristic of competitive firms. They are said to be price takers. That is, they do not have enough power to influence market prices (unlike for example a monopolist), since they only control a small share of the market. So no matter how much a competitive firm produces, price  will not change and revenue for each additional unit sold will be equal to the given market price. As a result, the marginal revenue curve will be a horizontal line at the level of the market price.

Marginal Costs

Most firms face increasing marginal costs as output increases. This is a result of diminishing marginal products.To give an example, think of a car factory that is currently producing at a low capacity. There are only few workers employed and the machines are barely used. If the factory increases production, idle capacities can easily be put to use and additional workers can add a lot of value. In other words, marginal costs are low and marginal product is high. However, if the factory is already running at full capacity, increasing production will be more expensive (e.g. because machines are overused) and additional workers will not add much value (e.g. because they have to wait to use equipment). Therefore, when output increases, marginal product diminishes and marginal cost increases. As a result, the marginal cost curve will slope upwards.

Illustration

As mentioned above, we can visualize the principle of profit maximization in a simple diagram (see below). The x-axis represents output quantity (Q), while the y-axis stands for costs and revenue respectively (C and R).

Illustration 1: Profit Maximization

The Marginal revenue curve (MR) is a horizontal line at the level of the market price (p*). The marginal cost curve on the other hand (MC) is upward sloping, as described above. The intersection of the two lines (O*) is located at the profit maximizing level of output (q*) for the given price level. It becomes apparent that shifting MR will affect the output quantity, but not the price level. Thus, profit maximization for competitive firms means, finding the optimal level of output for a given price.

In a nutshell

Firms in a competitive market can maximize profits if they produce up to the point where marginal revenue equals marginal cost (MR=MC). Marginal revenue for competitive firms is constant and equal to the price of the good or service sold. Marginal costs on the other hand are usually increasing as output increases, due to the diminishing marginal product.
It is important to note that even though marginal revenue and marginal cost curves may look differently for firms in other market situations (e.g. monopoly, oligopoly, etc.), the profit maximizing level of output will still be located at the intersection of the two.

Report from the GEN conference

Wednesday was the Government Economics Network's annual conference at Te Papa in Wellington. This year the theme was "The relevance of economics in a changing world".

The keynote presentation was from Stanford's Paul Oyer, "The more things change, the more they stay the same: Four economic ideas everyone should know". His core theme was that, although many people post the GFC have criticised economics for not predicting it, or not understanding it, or even for causing it, economics has core concepts that were valid pre-GFC and are just as valid now. He picked four - cost-benefit analysis, equilibrium, thinking on the margin, and the limits of markets, all operating in the context of people aiming to maximise something in an environment of limited resources - and gave lively examples (funeral parlours in Tennessee, dog care services in Georgia) where these principles played out in real life. However, he also felt (quoting Princeton's Alan Blinder) that too much of economists' attention is taken up with arcana, and that the practical, useful, workaday economics, far from the bleeding edge academic frontier, was relatively neglected. That said, he ended up by saying that economics remains a powerful way of better understanding the world we live in, of helping to operate businesses more efficiently, and of setting policy for the greater good.

Not everyone agreed with his view - there was one pointed statement-cum-question from the floor saying that economics had fairly and squarely walked us into the GFC mess, and that the economics trade is in denial if it thinks it didn't - but I felt Oyer was broadly on the right track. The babies and bathwater criticism of economics has always seemed overdone to me, and I'd probably chuck in some further concepts that have also had enduring value (trade-offs, for example).

The next session was on "Economic analysis for policy", which exposed us to some applied techniques. Leo Dobes from the Australian National University talked about options, and the importance of allowing for the value of options in making decisions, and Caroline Saunders from Lincoln showed us examples of choice modelling, trade modelling, and modelling of sectoral comparative advantage. The choice modelling in particular was fascinating: Caroline showed us a real world example of how it had been used to identify the importance of various consumer criteria (such as safety, sustainability, country of origin) to overseas purchasers of our agricultural exports, which in turn could be used to profitable marketing effect in different overseas markets.

The next session, on "Teaching economics at university", wasn't so great.

The first speaker, Michael Mintrom from Monash, spent a good deal of his time on bringing an investment perspective to public policy development, which I thought was fine in itself, but not fully on-topic. He did get round to what you might want to teach people in university, if they're going to provide that perspective, albeit late in the piece. And it was quite good when we got there: I jotted down cost-benefit analysis models, experimental design with control groups, comparative institutional analysis, ex post opportunity cost studies, how economic insights can support social outcomes, learning from policy mistakes and near-failures, setting students 'capstone' projects which combine theory and application.

I didn't enjoy the presentation by Victoria's Morris Altman at all, principally because the delivery was painful to sit through (screen after screen of text paragraph bullet points, read verbatim). His core point was that it is a good idea to bring a mix of techniques and perspectives to any given problem.

Ashleigh Cox, a master's student at Waikato, gave us an interesting perspective from the other side of the lectern. She was concerned that her undergraduate economics hadn't seemed to give her the insights she'd have liked on issues such as exchange rates, housing, or inequality, and that it was only later and further reading that left her better equipped (mind you, I'd say that's probably true of a lot of things, and most of us have learned more about a subject post school or post college than we ever learned at the time). And she was also concerned about what (I think) she called "economics imperialism", or economics attempting to be a Grand Theory of Everything, and not doing it well at all.

Her comments got the discussion going, both in the hall and around coffee afterwards. Mostly I got the impression that all is not as well as it might be with teaching economics in New Zealand (and there are similar discontents overseas). Comments I picked up: not enough real-world applied economics on the menu; three-year, short-trimester economics degrees don't leave enough room to add the bits that would give a broader perspective to an economics education (such as economic history, or the history of economic thought); not enough effort going into making sure that students have an intuitive understanding of concepts, as opposed to parroting back equations (I was suddenly reminded of a piece George Orwell once wrote about a rote-leaning school student in the UK blindly reciting, "The root cause of the French Revolution was the oppression of the nobles by the people"); and degree courses being overdesigned for the student on the PhD track (heavy on the maths and the theory).

I snuck in a "mostly" qualification earlier, and that's because I also talked to some (younger) people who were very satisfied with what they'd got in New Zealand. As was I with mine in Ireland (Trinity), but then I did get some economic history, and some compulsory politics options, that rounded things off better than some modern economics courses seem to manage.

And we finished with an excellent session on the "Economist as Policy Advisor", from two battle-hardened pros - Graham Scott, formerly Secretary to the Treasury, and the NZIER's John Yeabsley - who've seen it all, and have the war stories to prove it. Graham had led off with an impressively erudite history of the role of advisers to rulers, but we moved on from Athenian democracy to wrestling with Muldoon in short order. I'd guess the many policy analysts in the room will have taken away good ideas on how to handle some of the trickier issues - notably how to present advice that your Minister does not want to hear.

At the end we had an unscheduled appearance by one of those very Ministers, Max Bradford, who made two points that I recall. One was that the greatest difficulty he'd faced was breaking with the inertia of the status quo. The other was that it might have been useful to have had some Ministerial customers of policy advice on the panel for the session, to give their perspective, and I think he was right.

The picture of health

This chart, from the OECD's latest Health At a Glance publication, is going the rounds of the social media, and it's a bit of a reality check, in a good way. If you'd thought that we were all going to hell in a handbasket because of binge drinking, bad driving, obesity and all the rest of it, think again.

The graph shows people's self-reported state of health, and we're very near the global top. Even if you take off a positive bias for the way the question was asked in some countries (our score is 5-8% higher than it would be if measured the same as in most countries), we're still well up there.

How people feel about their health is one reasonably important outcome, but if we go away from perception and look at some of the hard numbers, we stack up pretty well, too. Here's life expectancy.

The wealthier OECD countries are all pretty much of a muchness, really, but again we're in a pretty good place. Interestingly, as the next graph shows, we have much less of a gap in life expectancy between the well-off and the poor than exists in most countries. No idea why this should be, but there you go - another pretty good outcome.

From an economist's perspective, it's interesting to see that we've got better health (measured by life expectancy) than you'd expect for a country of our income level, and better health than you'd expect for the amount we spend on healthcare, as the next two graphs show. In both cases you want to be north of the fitted black line, and we are. And it's interesting to see that some of the stylised facts we all 'know' about global healthcare are, indeed, true, notably the hopelessly inefficient level of the health spend in the US.

I know, I know, we could be even healthier again, and if we did a better job of managing the booze, the weight, the fags, the exercise, the diet and the heavy foot on the accelerator, we'd all be even better off. But at the same time we ought to take on board that as far as comparisons with countries like us are concerned, we're already making a pretty good fist of health outcomes.

That "heavy foot on the accelerator" isn't a random comment, by the way. I'm recently back from Ireland, where I couldn't help noticing how much more polite and orderly the driving is than here in NZ. And it shows in these OECD stats, too: neither country is a smash palace along Brazilian or eastern European lines (and America doesn't show to advantage, either), but Ireland's death rate on the roads is clearly lower than ours. Which is something you could think about next time you cut me off on the motorway.

Too many rules, not enough houses

Last month I wrote about some residual absurdities in Australia, where there were still bizarre examples of nutbar regulation of the retail trade, and this despite decades of economic reform that one might have expected would have swept away the last of the most egregious nonsense.

It left me feeling that "there are still thickets of regulation that are absolutely bonkers". At the end of the post I said that "the good news is that both Australia and New Zealand now have Productivity Commissions that are able to turn over the flat stones and tell us what they're finding underneath", and wondered "what we'd find if, for example, we turned over some flat stones of our own".

I didn't have long to wonder.

Along came the Issues Paper (pdf) for the Productivity Commission's latest project, on the availability of land for housing. And even at this early stage it has found multiple examples of over-prescriptive, inconsistent, complex, inefficient, expensive and (I would say) largely rationale-free regulation.
Here are some examples, direct quotes from the paper.

(1) A Ministry for the Environment review of Christchurch City Council planning and resource consent processes described the two Christchurch District Plans as:

…large, cumbersome and difficult to navigate. The City plan is effects-based, while the
Banks Peninsula plan is activities-based. There are a total of 109 different planning zones,each with varying provisions (p28)

(2) Auckland Council is currently in the process of developing its first Plan as a unitary council. The Proposed Auckland Unitary Plan (PAUP) will replace the existing Regional Policy Statement and 13 district and regional plans. Given the breadth of the material covered in the PAUP it is not surprising that the document is lengthy, but at 6 961 pages (at the time of writing) the PAUP is very unwieldy. Supplementary documentation acknowledges that the Plan is complex, but also suggests that users must read the full document:

       The Unitary Plan is a complex document that consists of many interlinked parts. One        must not look at any provision in isolation, but read it as a whole (p29)

 (3) the Ministry for the Environment notes that plans prepared by “the eight largest
territorial authorities showed 123 different terms were defined, with more than 450 variations of those definitions”...

A comparison of two Plans’ rules around car parking demonstrates the variation. The Käpiti Coast District Council’s Rules and Standards states that "All buildings shall be designed so that wherever practicable sufficient manoeuvring space on site will ensure no reversing onto the road is necessary." In contrast, Nelson City Council’s Residential Zone Rules state that "Reverse manoeuvring is encouraged on unclassified roads and is part of ensuring a low speed environment and people orientated streetscape." (p37)

(4) One way of enabling new types of land use is to change a Regional or District Plan. Changes to Plans can be sought by a local authority or a private party...

The average timeframe taken to complete a Plan change in 2012/13 was 24 months. This was an increase from 2010/11, where council-initiated Plan changes took 17 months to complete and privately initiated Plan changes took 16 months (p47)

No doubt some processes are working well, but in spots we've got regulations of a complexity that would tax a Talmudic scholar, a glacial pace of administration, and an absence of compelling logic, with things forbidden in one jurisdiction being encouraged in the next. And all this against a background of a bloated local administration superstructure. We're a small country, but even after a programme of local authority consolidation, we're still left with this (p16):

No wonder we get this outcome (p7).

The Issues Paper isn't all about the dead hand of local authority micromanagement - I've focussed on those aspects as I've got an interest in good regulation - and it canvasses a wide range of other factors affecting the availability of housing land. The Productivity Commission is looking for people to tell it whether it's on the right track with its initial ideas, and whether it's missed anything: in particular it has a list of 74 specific questions where it is looking to get feedback and information, though people are also welcome to submit their views outside the 74-question format (contact details are in the paper and here).

The state of the housing market is one of the bigger economic issues right now: take the opportunity to have your say on what's going on and what should be done about it.

The economy's still in good shape

Treasury's latest Monthly Economic Indicators came out today. Here's a selection of some of the bits I found interesting.

First, the current growth cycle is still in good shape. The NZIER's survey measure of firms' trading activity in September suggests the economy was still growing at about a 3% rate. As I've said before, I love these survey measures: they're quick, relatively cheap, and usually have dependable relationships with the big macroeconomic statistics.

Looking ahead, prospects are still pretty upbeat, too. In the chart below I've shown firms' hiring intentions, but I could as easily have picked firms' expected trading activity or firms' expected investment. It's all good.

You might well feel that we've had a bit of a blow to our export incomes given the degree of attention that's been given to lower world dairy prices, and while that's true to a degree, as the chart below shows it's not the whole story. For one thing, dairy products aren't the only things we sell: overall export prices have been hanging in there. And for another, import prices have been falling (and may well fall quite a bit further, if world oil prices keep sliding), so our overall purchasing power - our terms of trade, what we can buy with our export income - has actually been rising sharply.

And finally there's that unexpectedly low inflation rate that we've been having. As the chart below shows, there's generally been a fairly close link between various survey measures of firms' price setting and overall inflation, but over the last eighteen months or so actual inflation has come out lower than the surveys would have led you to believe. Some people have been climbing into the Reserve Bank for overestimating the likely inflation rate: well, don't be too quick to rush to judgement. On the traditional relationships, they were making a sensible call.

Why the relationship appears to have broken down, at least for now, is a big question, and one I'll probably come back to, but we are not alone. In many places around the developed world, inflation is turning out to be lower than central banks were steering for, as the chart below, from this article in the Economist, shows: look where the dark brown marker lies relative to the bright blue one (or to the white range between blue markers). Another reason not to get too into finger-pointing at our RB: there's evidently something happening at a global level here that's blindsided a whole bevy of central banks (or whatever the collective noun for central banks might be).