Short answer questions

1. With the help of a diagram, explain how it is possible for a firm in perfect competition to earn abnormal profits in the short-run.

The short run is a fixed plant period, which means that a firm is facing fixed costs as well as variable costs. The fixed costs are the costs of fixed assets a fgbirm uses, such as interest rate or land rent. Variable costs are the costs for each worker (wages). In the short run, firms can't enter or exit a market. Perfect competition is a market structure in which all firms sell an identical product. In a perfect competitive market all firms have a relatively small market share, there are no barriers to entry or to exit the market and they have a small and an equal size. Firms in perfect competitive markets are price takers which mean that they have no say in changing the prices of their product. They have to set the price as the market demands.
It is possible for a firm in perfect competition to earn abnormal profits in the short-run when it is covering more than their total costs, including their opportunity cost. A firm maximizes its profit when the marginal costs equal to the marginal revenue. It is producing at the industry price (P) and it is maximizing its profits by producing at the quantity (q). At q the costs per unit is C whereas the revenue per unit is P. Therefore the average cost is less than average revenue and the firm is making an abnormal profit on each unit (P-C). Because of the attraction of the abnormal profit to other producers, who will then enter the market, making abnormal profits is only possible in the short run. Due to the attraction and the increase in the number of firms in the market, the supply increases and the supply curve shifts to the right (S1). The price decreases from P to P1.

2. With the help of a diagram, explain how it is possible for a firm in perfect competition to earn abnormal profits in the long run.

The long run is also calls "variable plant period", which means that every cost a firm faces, such as rent, wages or interest rate, is variable. There are no fixed costs. Since the long run is the planning period, the costs a firm faces can be changed over time. Small firms which produce the same product outside of the market will start to entry the market because they are attracted by the chance of making abnormal profits. However, the more firms enter the market to make abnormal profits; the market supply for the product will increase rapidly. Therefore the supply curve shifts from S to S1. Since the firms in an industry are price takers, the price for the product will decrease. This leads to a downward shift in the demand curve. This means that the abnormal profits will start to be "competed away" and the firms make normal profits. Since the firms make normal profits, there is no attraction for other firms. Therefore the market will stay at the new equilibrium. Entrepreneurs are satisfied because they are covering all their costs, including opportunity costs.

3. Explain whether or not a firm in perfect competition earning abnormal profits is productively efficient.

However, a firm makes abnormal profits by maximizing its profit. In order to maximize its profits the firm produces at the quantity, where marginal costs=marginal revenue, as well as when the average total cost is less than the average revenue. There are two types of efficiency: Productive efficiency and allocative efficiency. Productive efficiency is when a firm in perfect competition is producing its product at the lowest possible unit cost (P= minimum ATC). The productivly efficient level is where MC=AC. When a firm is producing productively efficient they combine their resources as efficiently as possible, this means that resources are not being wasted by inefficient use. Allocative efficiency is also called the "socially optimum level of output", which means that this is also a point where a firm maximizes its profits. It is being defindes as P=MC=MR. When a firm is allocative efficient it produces the right amount so that the supply equals the demand. However, when the price is greater than the marginal cost, the producers know that demand for the product is higher. When the price is lower than the marginal cost, the product is not as much demanded as being produced. In the end it is clear that a firm in perfect competition is not producing at the most productvley efficient level of output. Hence it produces allocativley efficient.

Short response questions

1. With the help of a diagram, explain how it is possible for a firm in perfect competition to earn abnormal profits in the short-run
   

It is possible for a firm in perfect competition to earn abnormal profits in the short-run when it is covering more than their total costs, including their opportunity cost. It is producing at the industry price (P) and it is maximizing its profits by producing at the quantity (q). At q the costs per unit is C whereas the revenue per unit is P. Therefore the average cost is less than average revenue and the firm is making an abnormal profit on each unit (P-C).

2. With the help of a diagram, explain how it is impossible for a firm in perfect competition to earn abnormal profits in the long run.

At first, firms outside of the industry which could also produce the good will start to entry the industry. These small firms are attracted by the chance of making abnormal profits. In the beginning, this will have no real effect. However, the more firms enter the industry; the industry supply curve will start to shift to the right. The firms in the industry are price-takers which leads to a fall in price. The demand curve will shift downwards which means that the abnormal profits will start to be "competed away" and the industry makes normal profits. Entrepreneurs are satisfied because they are covering all their costs, including opportunity costs.

3. Explain whether or not a firm in perfect competition earning abnormal profits is productively efficient.

A firm in perfect competition is productively efficient if it produces its product at the lowest possible unit cost (average cost). The productively efficient level is where MC=AC. However when a firm is making abnormal profits it is producing at the profit maximizing level of output (MC=MR) and the allocatively efficient level of output (MC=AR). This shows that the firm is not producing at the most efficient level of output (MC=AC).

Russian Government sets taxes on beer!

Sin Tax Error - the Economist.com

In Russia, half of premature deaths are linked to drinking. For this reason, the Russian government wants to reduce the demand for alcohol by setting a tax on beer. This means that the government puts a fee charge on beer. It is expected to reduce the amount of beer consumed in favor of an increase in consumption of vodka. Already this year, Carlsberg has suffered a 10% drop in the consumption of its beer. The assumption is being made that due to the higher price, the demand will decrease by a further 25-35% in year 2012. Although the reasons given for the tax increase on beer are related to health, the change will have the effect, that Russians will rather drink vodka.

This extract mainly talks about demand, supply, PED, substitutes and government taxing. Before taxing a product, the demand and supply of beer is in equilibrium. This means that the quantity demanded equals the quantity supplied also known as "a state of rest".

However, when a product is taxed higher (e.g. beer) the price will increase and the supply curve shifts to the left. Supply depends on the willingness and ability of producers to produce their product at a given price in a certain amount of time. Due to the tax on elastic good (a good for which consumer's responsiveness is high), the quantity demanded decreases. Quantity demanded defines the willingness and ability of consumers to buy a good or service. When a good is elastic, the PED is greater than 1. PED is the measure of responsiveness of consumers in a change in price for a good or service. Therefore the price for an elastic good cannot be at the maximum since the consumption of the good would decrease. Elastic goods often have substitutes.

In this article the government of Russia sets a tax on beer. Since the assumption is being made that the price will increase by about 25% and therefore the quantity demanded for beer will decrease by about 30% over the next 3 years due to the sin tax on beer; PED can be calculated. The general formula for PED:

PED = % change in quantity demanded / % change in price

PED = -30/25 = 6/5 = 1.2

Given that PED of beer is 1.2, it is an elastic good. The Diagram on the right represents the beer market. The Demand and Supply curve mark the equilibrium (Pe/Qe). As soon as the beer is being taxed more, the supply curve shifts to the left (Stax). This indicates the decrease in quantity demanded since the price of beer increases (price increased from Pe to Ptax and quantity demanded decreased from Qe to Qtax). The yellow marked area symbolizes the producer burden; the green shaded area is the consumer burden. Since the consumer is responsive to an increase in costs, the producers have to cover most of the cost. Otherwise the consumers would not buy the goods. The Diagram also shows a big area of dead weight loss (red shaded). Consequently it shows how the producers suffer under the beer tax since they have to cover most of the government imposed costs even though some don't earn enough money to do so.

Since vodka is also alcohol, it is a substitute for beer. Since the tax on vodka is unchanged people rather buy vodka instead of beer. This leads to an increase in the vodka market, illustrated by the Diagram on the left. "D" demonstrates the original demand curve with the price and quantity demanded. However, since only beer is being taxed higher, the demand for vodka rises (Q2). However to be in equilibrium, the price of vodka rises to (P1/ Q1). Hence the demand curve shifts to the right due to the increase of quantity demanded (Q to Q₁). So while the beer market suffers under the sin tax of beer the vodka market makes an enormous profit.

In the article it says "The government claims that the measure will raise money to fight the ravages of alcohol in a land where half of premature deaths are linked to drink." In my opinion, setting a tax on beer is not beneficial. On one hand, taxing alcohol is a good idea; on the other hand, taxing beer alone does not help to reduce the consumption of alcohol. Instead of taxing only beer, which does not have a high percentage of alcohol, the government should tax drinks, which have a much higher percentage of alcohol, such as vodka or whisky. If vodka or a similar drink would be more expensive due to taxes then there is a higher possibility for less drinking in the name of public health. I agree with the statement "Pushing up beer prices is far more likely to encourage drinkers to swallow even more vodka or dodgy but cheap home-made spirits than to convince them to give up booze altogether."