Terms and concepts

Perfect competition: An industry structure in which there are many firms, none large enough to influence the industry, producing homogeneous products. Firms are price takers. There are no barriers to entry. Agriculture comes close to being perfectly competitive.

A firm in a perfectly competitive market may generate a profit in the short-run, but in the long-run it will have economic profits of zero.

. A perfectly competitive market has the following characteristics:

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  There are many buyers and sellers in the market.
  
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  Each company makes a similar product.
  
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  Buyers and sellers have access to perfect information about price.
  
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  There are no transaction costs.
  
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  There are no barriers to entry into or exit from the market.
  

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  Total Revenue = Price * Quantity
  
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  AR (Average Revenue) = Total Revenue / Quantity
  
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  MR (Marginal Revenue) = Change in Total Revenue / Change in Quantity
  

Profit maximization

In order to maximize profits in a perfectly competitive market, firms set marginal revenue equal to marginal cost (MR=MC).

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  Market failure occurs when the price mechanism fails to account for all of the costs and benefits necessary to provide and consume a good
  

Possible government responses include:

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  legislation – enacting specific laws. For example, banning smoking in restaurants, or making high school attendance mandatory.
  
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  direct provision of merit and public goods – governments control the supply of goods that have positive externalities. For example, by supplying high amounts of education, parks, or libraries.
  
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  Air pollution: Air pollution is an example of a negative externality. Governments may enact tradable permits to try and reduce industrial pollution.
  
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  taxation – placing taxes on certain goods to discourage use and internalize external costs. For example, placing a ‘sin-tax’ on tobacco products, and subsequently increasing the cost of tobacco consumption.
  
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  subsidies – reducing the price of a good based on the public benefit that is gained. For example, lowering college tuition because society benefits from more educated workers. Subsidies are most appropriate to encourage behavior that has positive externalities.
  
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  tradable permits – permits that allow firms to produce a certain amount of something, commonly pollution. Firms can trade permits with other firms to increase or decrease what they can produce. This is the basis behind cap-and-trade, an attempt to reduce of pollution.
  
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  extension of property rights – creates privatization for certain non-private goods like lakes, rivers, and beaches to create a market for pollution. Then, individuals get fined for polluting certain areas.
  
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  advertising – encourages or discourages consumption.
  
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  international cooperation among governments – governments work together on issues that affect the future of the environment.
  

Reasons for market failure include: