Explain the Benefits of Perfect Competition and The Downsides of Market Power below using economic terminology, economic logic, and economic reasoning

1) The Benefits of Perfect Competition

The essence of a market economy is that all economic activities in a market are voluntary. Businesses choose to produce and sell because they benefit by earning the highest profit possible. Buyers make purchases because the value of the goods or services to them is greater than the prices they pay. In a market, all trades of money for goods and services are mutually beneficialboth buyers and sellers win.

But perfect competition goes further. In a market with perfect competition, businesses are price takers. As long as the market price exceeds the marginal cost, businesses automatically choose to increase output. To put this another way, as long as buyers are willing to pay enough to cover the extra costs of production, suppliers will oblige them.

To better understand the benefits of perfect competition, think again about that tuna sandwich you might buy at a local restaurant. Suppose you are willing to pay $3 or less for it. Now suppose its marginal costthe cost of the ingredients and of the cook's time to make itis only $2.50. As long as the price of the sandwich is between $2.50 and $3.00, the restaurant can profitably sell the sandwich, and you will be willing to buy it.

In perfect competition, that tuna sandwich will always be made and eaten. If a restaurant is not willing to make it for you, the one next door will. In essence, that's what perfect competition meansthere are plenty of potential suppliers.

This idea holds not just for sandwiches but for any other type of good or service sold in perfect competition. Perhaps you want to buy an office chair. As long as the marginal cost of producing that chair is less than the price you are willing to pay, in perfect competition you will be able to find a business willing to make and sell the chair to you.

2) The Downsides of Market Power

A profit-maximizing monopolist will always charge a higher price than a perfect competitor would. More generally, monopoly, monopolistic competition, and oligopoly all feature sellers with some degree of market power. Market power is the ability to raise prices above the level that perfect competition would produceby restricting the quantity supplied.

Higher prices and lower quantities supplied lead to higher profits for a business with market power. These higher prices hurt customers, of course. What's more, businesses with market power have to artificially hold down production and sales to keep up their prices.

Let's examine the general problem of market power using Figure 5.5. In perfect competition, suppliers and buyers reach the market equilibrium A where price equals marginal cost. Now let's suppose suppliers have some degree of market power. They band together and raise the price a bit to boost their profits. Buyers cut back on purchases because of the higher price (the result of a downward-sloping demand curve). The new market equilibrium is point B on the graph, and the new quantity supplied is less than the original quantity supplied.

Suppose a town has lots of restaurants engaged in cutthroat competition. As a result, the restaurants charge $10 per person for their meals, just enough to cover the cost of the ingredients in the meals plus the labor required to prepare and serve them. Everyone in this town, even relatively poor people, can afford to eat out once a week. The restaurants are not making much moneyjust enough to stay in business. This is point A in the diagram.

Now imagine that the restaurant owners get together and agree to raise the prices they charge for their meals. So instead of charging $10 per person for dinner, they charge $15. What happens? In the diagram, the new market equilibrium corresponds to point B. The poorer people in this town stop eating out. The middle class eats out less often. The number of meals served drops significantly.

The restaurant owners are making more moneyor they wouldn't have raised their prices. The people of the town are worse offpaying more and eating out less. But perhaps most important, dinners that could have been served aren't. This decrease in production and consumption represents a real loss to society.

SPOTLIGHT: THE AUTO INDUSTRY

For many years after World War II, the Big Three automakersGM, Ford, and Chryslercontrolled the U.S. auto market. They were able to keep prices high enough to earn good profits and often made local car dealers wealthy. Autoworkers did well too. They were among the best-paid factory workers, with generous benefit packages that included free health care even after retirement.

The market power of U.S. automakers began disappearing in the 1970s, when competition arrived in the form of Toyota and other foreign automakers selling small, fuel-efficient cars that the Big Three didn't have. Detroit's market power gradually ebbed, and the Big Three could no longer boost prices as fast as overall inflation. In fact, from 1997 to 2018, the average price of new vehicles sold in the United States, adjusted for quality, didn't rise at all, which benefited car buyers. The market power of U.S. automakers had virtually vanished.

Source: Bureau of Labor Statistics.

Market power has other consequences, in addition to higher prices for buyers. Managers at a business with market power have little incentive to cut costs. As a result, they can choose to raise wages for themselves or for their employees above what similar workers are getting paid. This helps workers at those businesses at the expense of consumers. Market power can make work easier for managers and workersbut it may not be the best thing for society.

Alternately, businesses with market power have sometimes used their high profits to research new products and technologies with long-term payoffs. The classic example is the old AT&T, which had a near-monopoly on telephone service in the United States until 1982. It used its powerful position to do some of the most important research in the country such as the invention of the transistor and the laser. Businesses with market power have also been big contributors to charity and cultural institutionsonce again drawing on their higher profits.

Nevertheless, most economists believe that an economy with more competition performs better in the sense that it has higher production levels and lower costs. As we proceed through this textbook, we will return to this theme.