Lewis 1
Ethan Lewis
Brandon Coe
Principles of Microeconomics
2 August, 2017
Microeconomics Research Paper
The economic theory of business behavior is founded on the assumption that a firm’s
overall goal is to maximize profit. In a perfectly competitive market, if one firm is realizing an
economic profit, that usually means that another is doing the same or trying to. This idea is best
illustrated by the Invisible Hand theory. The Invisible Hand is a term used by well-known
economist, Adam Smith, in his book “The Wealth of Nations”. Our textbook’s definition of the
Invisible Hand Theory is the actions of independent, self-interested buyers and sellers will often
result in the most efficient allocation of resources. In this theory, market price serves two distinct
functions. First, price influences how much of each type of good gets produced, also known as
the allocative functions. Second, the rationing function, explains that prices direct existing
supplies of goods to the buyer who value them the most. Furthermore, this theory describes the
unobservable market force that helps the demand and supply of goods in a free market reach
equilibrium. Naturally, a firm wants to earn more than a normal, profit, and no one wants to earn
less. Thus, a market where firms are earning an economic profit will attract new firms to enter
this market, shifting the supply curve to the right, reducing the price of the product. This process
will continue until economic profit is driven down to zero and the market has reached
equilibrium. Markets where firms are experiencing an economic loss will have the opposite
effect. Firms will exit the market decreasing supply and increasing price. In the long-run,
weather the firms is experiencing a profit or loss the value of the last unit of productions will
eventually equal to its marginal cost of production, eliminating any opportunities for gain.
In Adam Smith’s theory, it is assumed that the market is perfectly competitive, or no
individual supplier has influence on the market price of a product. However, imperfect markets
due exist, and therefore there are ways in which the Invisible hand theory fails. When a firm has
market power they have influence on market price. There are several ways to gain market power.
For one, a firm can have control over inputs that are essential to production for a certain product.
They can establish patents or copyrights on new products. They can obtain government licenses,
form economies of scale, and install network economies. All of which provide market power.
Lewis 2
Another example of an imperfect market is a monopoly. For any firm the overall goal is to
maximize profit. In a perfectly competitive firm and a monopolistic firm profit is maximized at
the output level where marginal revenue equals marginal cost. The only difference is that when a
perfectly competitive firm’s marginal revenue equals the market price, it is always less than the
market price for a monopolist. Because maximizing price is less than revenue, the benefit to
society of the last unit produced must be greater than the cost of the last that unit. So the output
level for an industry served by a profit-maximizing monopolist is smaller than the socially
optimal level of output. This profit-maximizing rule interfere with this this level of output further
when cartels are formed among firms. Our textbook provides an example of a cartel situation that
involves two oligopolists selling bottled water. If either one of those firms decides to sell their
water at a lower output than the other than they will acquire the entire quantity demanded. This
type of situation illustrates a prisoner’s dilemma, which is where most cartel agreements take
place making them almost unstoppable.
Public Policy in the US always brings up controversial issues. Some of these issues
include, the rising cost of health care, environmental pollution, policies for reducing poverty, and
