Technological advance contributes enormously to economics efficiency. New and better products and processes enable the society to produce more goods at a less price, and produce a higher-valued mix of output.
Technological advance improves productive efficiency by increasing the productivity of inputs and by reducing the average total costs. In enables society to produce the same amount of goods and services by using fewer resources, so that it frees unused resources and produce something else from them. If society needs now more less-expensive goods, process of innovation helps to gain greater quantity of output by sacrifying fewer resources used as input. We may state that process innovation increase productive efficiency: it reduces society’s cost of whatever mix of goods and services it wants and thus it is an important factor that shifts economy’s production possibilities curve by shifting it rightwards.
Technological advance used at production process of various goods increase the allocative efficiency by giving society more desired mix of goods and services. Consumers are willing to buy a new product rather than an older one only if the new one increases the total utility obtained from usage of the same quantity of scarce resources. That’s obviously that new product (and new mix of products) will create a higher total utility for society. That’s why demand for old product declines and demand for the new one increases. High economic profit gained from the new product attracts resources away from less-wanted by society uses to the production of new item. This shifting of resources continues until marginal cost and marginal benefit equalize each other.
However, innovation (either of product or price) may create a monopoly power in the market through patents and through other advantages of being first. When a new monopoly power results from an innovation, society may lose a part of its efficiency it otherwise would have gained from this innovation. The reason is that monopolist may keep product’s price above marginal cost.
Innovation may reduce or even destroy monopoly power by providing competition somewhere it didn’t previously exist. Economic efficiency is enhance after this event occurs, because this new product helps to push the prices down, close to marginal cost and minimum average total costs (ATV). Innovation that leads to greater competition in an industry reduces output-restrictions and monopoly prices.
Innovation may even generate a creative destruction, in which creation of new products and production methods simultaneously destroys the market position of existing monopolies and old ways of doing business.
Examples of creative destructions: movies brought new competition to theatres, which can be shown one at a time, but movies latter were challenged by television, aluminum cans and plastic bottles also displaced glass bottles in many uses, e-mail has challenged the postal service.
Schumpeter says that an innovator will displace any monopolist that no longer delivers superior performance, but this idea is most treated as a wishful thinking nowadays. In this view, idea that creative destruction is automatic, but it neglects somehow the ability of well-established firms to provide shelter by themselves or by lobbying government to do it. This idea ignores differences between legal freedom of entry and economic reality of entering potential newcomers to concentrated industries.
In this case dominant firm(s) may use strategies as buyouts, selective price-cutting, massive advertising to block the entry and competition from existing rivals and appearing innovative firms. Moreover, some firms may be able to persuade government to give them subsidies, tax-break, tariff-protection to strengthen their market power.
In conclusion, while innovation increases economic efficiency; in some cases it may lead to expanding of monopoly power. Moreover, innovation may destroy monopoly power, but this process is neither automatic nor inevitable. However, technological change, innovation and efficiency doesn’t always bring monopoly power.
Cartels (that are a formal agreement among various firms in industry to set the prices of products and establish the outputs of the individual firms or to divide the market among them) and other arrangements are difficult to create and to maintain. Let’s describe some barriers to collusion for various industries:
Demand and Cost differences
Oligopolists face different cost of production and demand curves, so it’s difficult for them to agree on price, which is true for industries that produce differentiated products and change them frequently. Even if firms have standardized products, they usually have different market shares and operate at different degrees of productive efficiency. That’s why even homogeneous oligopolistic firms may have different demand and cost curves.
Differences in demand and cost mean that even profit-maximizing price and output will be different among firms; there will be no single price acceptable by all firms. Price collusion depends on concessions and compromises which are not easily to obtain, since there are many obstacles to collusion.
Number of Businesses
So, it’s obvious the fact that more firms being present in an industry, harder is to create a cartel or other kind of price collusion. An agreement on price set is relatively hard to accomplish when there are 3 or 4 firms, but what if there are 10 firms that share each about 10% of the market, or there is Big Four that has about 70 percent of market share, and there are 4-5 small firms that have other 30% of this market share.
As it was explained in Game Theory model (previous article), there is a high-temptation for collusive oligopolistic firm to make a secret cut in price that may result in increased revenues. So buyers that are getting price cut by one supplier may wait for price-cut for another. Buyers may attempt to create a play between these two firms, so that it may transform into a real war. Even if cheating between collusive oligopolists may be profitable, this act is destructing it over time. However, collusion is more likely to succeed when cheating is easier to observe and punish.
Greater revenues may result in attracting new firms in this industry. Since this may create increased market supply and reduced prices, successful collusion of oligopolists requires them to block the entry for new producers.
Recessions serves as enemies to collusion, since markets will increase average total costs (ATC), because oligopolists’ demand and marginal revenues (MR) will decrease in response to this recession. Firms will find out that the quantity supplied by them is in excess, so these firms will have to avoid great profit reductions (or losses) after cutting prices and thus they will gain sale at expense of rivals.
Anti-combined law (legal barrier)
Many countries have anti-combined laws that prohibit this price-fixing collusion, so this means that they have a system of price control.
A purely competitive industry whether decreasing cost, increasing cost or a constant cost one should have some basic characteristics so that in long-run we may be able to talk about its economic efficiency. In a long Run a triple equation exists: P (Marginal Revenue) =MC =minimum ATC, which besides giving us information about economic profit or loss that our firm gains in short-run, tells us that in long-run a firm may get only a normal profit. This equation also suggests certain conclusions about Allocative and Productive efficiency of our economic unit in long-run.
Productive efficiency requires goods to be produced at least costly way, but allocative efficiency requires goods to be divided among industries that yield most needed combination of products by society. Let’s see how productive and allocatice efficiency is realized in purely competitive market.
Productive efficiency: P= Minimum ATC
In long run, pure competition forces firms to produce their goods at minimum average total costs and to charge price relative to cost of production, which is a situation that benefits consumers. If firms don’t use these least-cost production methods they may get high losses and at a point in time leave the market. In this case minimum quantity of resources is used to produce these goods.
Let’s take for example a firm that produces 1000 kg of tomatoes. To cover all its cost of production it should sell all this quantity at price of 5$ per kg ( 5000$ totally). If another firm produces the same quantity for 9000$ then society will face a loss of 4000$ of alternative products. However, this loss can’t happen in pure competition, because this big loss may require our firm to leave the market.
Consumer benefits this kind of efficiency by paying lowest possible cost.
Allocative Efficiency: P=MC
Productive efficiency alone doesn’t ensure to get the efficient mix of good, also least cost production must be used to provide society the most needed mix of products. But what does the products’ price means?
- Price of any product is the society’s measure of marginal unit of a good. Price of a tomato is the marginal benefit society gets from using it.
- Price of one more unit of any good is the opportunity cost society sacrifice to get it. If we produce any additional tomatoes we sacrifice growing more units of corn.
Let’s see the cases when this equation doesn’t take place.
In pure competition a firm realizes the maximum profit when price of a good equals to its marginal cost. Producing tomatoes at points where MR (Price) is greater than MC (P>MC) yields less than maximum profit. This means that society is underallocating resources for producing this good, so that one more unit of tomato is valued by society higher than other products that our resources can produce.
Production of tomatoes shouldn’t go beyond the price where marginal cost exceeds marginal revenue (Price). If we produce at a point where MC (marginal cost) is higher than marginal revenue, than the producers won’t obtain maximum profit. So it is an overallocation of resources to this produce. In our case by producing tomatoes at the point where (P<MC) means that we sacrifice goods used at production of tomatoes, which society values higher than tomatoes.
So conclusion is that in a pure competition, firms should produce at a point where MR(Price)=MC, so that each item will be allocated efficiently in our society. To produce cucumber at a point where P>MC, means that we sacrifice production of goods, which society values very high, but at the point where P<MC it’s overallocation of resources, at production of which are used resources that may produce goods valued higher.
Another important characteristic of purely competitive market is ability to change quantity output when there are some changes in consumer’s taste. So if cucumbers now become more popular initially their price will increase, so that P>MC, this fact will permit cucumber industry to take away resources from less profitable uses, let’s say potato. So cucumber industry will expand.
Similarly a change in supply of a particular resource will create a change in labor force, production technique or capital (machines). Thus managers have to reallocate all resources very fast until P=MC.
Highly efficiency of allocating resources in a purely competitive market makes resource suppliers to seek to further their self-interests. This is the invisible hand which operates in our competitive market system. This kind of market system not only makes a patter to maximize profits but also maximized consumers’ satisfaction. Invisible hand operates good suppliers in such a way that society’s interests are maximized by using scarce resources.
Free International trade has brought a harsh competition among producers from different countries. Imports have an important effect on different industries from any country. Also many firms from, let’s say, Japan have become very wealthy and well-known on international market like: Nintendo, Sony, Honda, Panasonic, Mitsubishi. However, there are a lot of firms that can’t compete, because their international competitors make better quality products or price of their goods are relatively lower, or even both these qualities may be present.
So is this competition among firms from the entire planet good or bad? Even if domestic producers may get hurt and a lot of people should find new jobs, foreign competition clearly benefits consumers and society in general. Imports break down monopoly of existing firms, and decrease the price of goods and services. Foreign competition forces domestic producers to improve their production quality and productive efficiency. However many domestic firms may compete successfully in the global market system.
What about Firms which aren’t able to compete? The truth is that they should go out of business. Economic losses mean that the scarce resources aren’t used efficiently. Alternative uses of them may be more profitable and improve the output of the whole country.