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Economics Essays | Equalibrium In Competitive Markets

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Part One - The theory

In order to explain the theory of long-run equilibrium in competitive markets, it is important to define under which conditions a market is considered perfectly competitive. The theory of competitive markets rests on three basic assumptions:

1. Firms are price-takers, which mean that, since none firm has a significant market-share, all of them take the price as given. Their decisions do not affect the market.

2. The product is undifferentiated, or in other words, one firm's product perfectly substitutes the other firm's.

3. Free-cost entry and exit, meaning that a firm can easily enter or exit the market with no special costs.

In addition, it is important to clarify the difference between accounting profits and economic profits. Accounting profit is measured by the difference between revenue and costs while economic profits take into account the opportunity cost of capital.


Theory of long-run equilibrium in competitive markets
This theory holds that in competitive markets, firms’ long-run economic profit is zero. The zero economic profit implies that the firm is earning a competitive return on that investment. It means that, the capital is
being as well invested as it could be in anywhere else. In this equilibrium, the firm has no incentive to exit the market nor does any other firm have incentive to entry. The underlying assumptions of the long-run competitive equilibrium are:

1. the firms in the industry are maximizing profit
2. all firms are earning zero economic profit
3. The price is such that the quantity demanded by consumers is equal to that produced by suppliers.

Suppose that in a specific industry, firms are operating with economic profits higher than zero. Hence, firms outside the market have the incentive to enter since the market is allowing the firms to have profits higher than competitive profits. The firms will entry, shifting the supply curve to the right, lowering prices and increasing quantity supplied, until the zero economic profit is reached.
Now, suppose that a firm decides to enter in a market in equilibrium. The additional quantity being supplied shifts the supply curve to the right, decreasing the price as a result of an increasing in quantity. Then, the firms will exit the market until the equilibrium is reached again.

Part Two – The Real World

The industry I chose to apply the theory is the investment banking particularly in Brazil. The product I will focus on is the US-Dollar - Brazilian Real FRA (Forward rate agreement). The customers are mainly multinational companies aiming at protecting their revenues or capital against currency volatility.

If we consider the periods of relative stability in the Brazilian currency markets, mainly prior 1999 devaluation, the market is very close to the definition of competitive markets:

1. Banks were price-takers facing a horizontal demand curve, being the spread charged only to cover basically credit risk and operating costs.
2. The product was undifferentiated, or in other words, almost every bank offered the same contract, and the differences in terms of banks’ credit risk perceived by firms were negligible.
3. Free-cost entry and exit, meaning that for banks were very easy to create a Sales Desk to trade with the customers whenever the profits justify doing so.

Hence, in this scenario, that specific industry within investment banking industry was very competitive and in the long run seemed to be in equilibrium:

1. the banks were maximizing profit
2. all banks are earning zero economic profit in that particular activity
3. The price of that product, as in any other financial market, was implied by the demand and supply curves.

But in the 1999 crisis, during the period comprising the months just before and those right after the devaluation, the picture was very different and the market did not behave as a competitive one.

Firstly, since the companies credit risk changed significantly, the banks’ mark-up was much higher. In addition, companies, fearing a default of small banks, were allowed by their headquarters to trade only with a select group of banks. This discrimination increased the spread banks charged them making their economic profit much higher than zero. Since the market, as response to the crisis, shrank as several banks were avoiding speculative and proprietary positions, the banks willing to trade had a considerable influence on the market. The product, viewed now as a combination of the product itself plus the counterpart, was no longer undifferentiated. Finally, the cost of entry turned to be very high since it involved among other factors credibility.

In conclusion, this specific industry seems to validate the theory in stable markets but not during financial crisis and I expect this behaviour to be held in the future. During turmoil, due to the reasons explained above, the market approximates more to an oligopoly than to a competitive market.