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10 views8 pagesBertrand russell

Mar 06, 2016

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Bertrand russell

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Bertrand russell

© All Rights Reserved

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EC4408/4608: Industrial Organisation and Regulation

1. Basic Assumptions

Consider the following model of imperfect competition in a market for a

homogeneous product.

There are m identical consumers. Each consumer has utility function

u( x , z) ( x ) z ax

b 2

x z

2

(1)

where x is the consumer's consumption of the product in this particular industry, and

z is expenditure on all other products. z is numeraire and the price of z = 1.

If p is price of x, then it is easy to see that, provided the consumer spends a positive

amount of income on both goods, the individual demand for x is given by the

equation

p.

( x ) a bx

(2)

In all that follows I assume that the consumer always spends a positive amount on

both goods and consequently the individual demand for x is given by the conventional

linear demand function (2).

Notice that the demand function given by (2) is independent of income. Thus the

compensated demand for x is identical to the Marshallian demand for x. Hence the

area under the Marshallian demand curve provides an exact measure of the consumer

benefit from consuming x units of commodity x. That is the money measure of the

benefit a consumer gets from consuming x is just

( x ) ax

b 2

x

2

(3)

We now want to move from individual demands and benefits to the aggregate demand

and benefit of all m consumers. So let X mx be the aggregate demand for x.

Then from equation (2), the (inverse) aggregate demand function is

~

b

p( X ) a bX , where b .

m

(4)

Notice that the larger the size of the market (the larger m ) the smaller is b i.e. the

flatter the aggregate demand curve.

If the aggregate consumption of x is X then the aggregate consumer benefit from

this is

X b~ X 2

b

X

CB( X ) m m a aX X 2

2

m

m 2 m

(5)

In other words the aggregate consumer benefit is just the integral under the aggregate

Marshallian demand curve.

Notice that the marginal benefit to consumers from having one additional unit of

aggregate output is just

MB( X ) CB ( X ) a bX p( X )

(6)

Having specified the consumer side of the market, let us now specify what is

happening on the production side.

Suppose now that there are n firms in the industry. For the moment n is fixed.

Each firm has cost function

where a d 0;

c( q ) dq F

(7)

F 0.

The assumption that a > d guarantees that the maximum price a consumer is willing

to pay for x is greater than the minimum marginal cost, and so ensures that in

equilibrium good x will always be produced. Marginal cost for each firm is clearly

d 0 , which is independent of output, so there is constant marginal costs. F 0

corresponds to the case where there are increasing returns to scale in production, since

average cost of production is falling with output.

Welfare

Suppose that each of these n firms produces some output q. Then the total benefit to

society from having n firms each producing output q, is just the difference between

the total benefit to consumers from having this amount produced and the total

resources (costs) used up in production. Thus

CB(nq) p(nq).(nq) n pnq). q c(q )

(8)

The first term on the RHS of (8) is just aggregate consumer surplus: the difference

between the aggregate benefit to consumers from consuming aggregate output nq

and the total amount they are willing to pay to consume this total output. The second

term on the RHS is the total producer surplus (profit) made by each of the firms.

Thus total welfare is just the sum of consumer surplus and producer surplus.

2.

returns to scale, which, in this context means assuming that F = 0. Conventional

static analysis also takes the number of firms as given. We then compare the amount

of output produced by each firm in some kind of imperfectly competitive equilibrium

to that which would be produced in the optimum.

Equilibrium

We now consider a COURNOT equilibrium. Here, each firm takes the output of all

the other firms as given, and chooses its own output to maximise profits. Thus if one

of the firms chooses output q, taking each of the other firms' output as fixed at q ,

then the firm perceives the relationship between price and its own output as being

p a b q (n 1)q ,

and therefore chooses q to

MAX q a b q ( n 1) q dq

The first-order condition for an interior solution is

MR a b(n 1)q 2 bq d MC

i.e.

q

a d n 1

q

2b

2

(9)

(10)

(10) defines this firm's reaction function - which gives the level of output chosen

by this firm as a best response to any arbitrary level of output chosen by all the other

firms. Notice this is linear and downward sloping.

Of course the level of output chosen by each other firm is not arbitrary and will be the

best-response by that firm to the level of output it perceives all other firms as

choosing. Hence, in equilibrium it must be the case that q q , and so the

equilibrium level of output chosen by each firm, must be given by

qe

ad

b(n 1)

(11)

Q e nq e

( a d )n

b(n 1)

(12)

p e a b(nq e )

( a d ) d (n 1)

d MC

(n 1)

(13)

From the first-order condition for profit-maximisation (9), it follows that the

equilibrium profit of each firm is

b. q

e

e 2

1 ad

.

b (n 1)

(14)

(i)

qe 0 ;

(ii)

pe MC e .

(iii) Given our assumption in this section that F = 0, then, from (14) profits are

always positive.

Welfare Analysis

As explained in (8) the net benefit to the economy of having these n firms each

produce an output q is just the difference between the aggregate consumer benefit

and the total resource costs used up in production.

B(q, n) CB(nq ) nc (q )

Assuming the number of firms is fixed, the optimum level of output for each firm, q ,

must satisfy the condition

Bq, n

nMB(nq ) nc (q ) 0

q

i.e.

p MB(nq c (q ) MC .

That is, we get the conventional prescription that the optimum level of output is

achieved where price equals marginal cost.

Using the particular functional forms, it is easy to see that this implies

p d ,

and so

q

ad

,

bn

and

(15)

(16)

(a d )

Q nq

b

(17)

We have already seen that p e d p , and it follows from comparing (16)

with (11) that, as we would expect, that q q e , and so obviously Q Q e . Thus the

market failure arising from imperfect competition is that output is too small and price

too high.

1)

2)

Given the assumption that F = 0, the optimum allocation could be achieved

by perfect competition. Under perfect competition firms operate where price equals

marginal cost. But since marginal costs are constant, each firm (and hence the

industry) has a completely elastic supply function at the price p = d. So perfect

competition would certainly achieve the right equilibrium price and output.

3)

Notice that the optimum price and the optimum industry output do not in any

way depend on n. If we did have perfect competition then each firm would be

making zero profits, so the equilibrium number of firms under perfect competition is

indeterminate. Put differently, under standard conditions of constant returns and

perfect competition both the equilibrium and the optimum number of firms is

indeterminate, and so it doesnt make sense to ask whether markets get the right

number of firms.

To understand just how much of a welfare loss arises from our imperfectly

competitive equilibrium, substitute q into (8) we find that the benefit from having

the optimal level of production is

(a d ) 2

B

2b

(18)

while, by substituting q e into (8) the benefit from having the equilibrium level of

production is

Be

n(n 2)( a d ) 2

2

2b n 1

(19)

The welfare loss from having equilibrium production rather than optimal production

is therefore

(a d ) 2

2b

n(n 2) (a d ) 2

1

2b

n 1 2

1

(n 1) 2

(20)

If, following Harberger, we write this welfare loss as a percentage of the level of

welfare in the optimum then we get the Harberger welfare loss from imperfect

competition, H, which is given by

L

1

2

B (n 1)

(21)

So, for example, if we had pure monopoly (n = 1) the welfare loss would be 25% of

GNP. If we had 9 firms in the industry the loss would be 1%, and if we had 13 firms

in the industry the welfare loss would be just over 1/2 of 1% of GNP - the sort of

figure that Harberger came up with.

Now so far we have just taken number of firms as given and have looked at loss from

having the wrong level of output. Have we any reason to believe that markets

produce "right" number of firms ?

To address this question we need to consider a more dynamic analysis in which we

make the number of firms variable when considering both the equilibrium and the

optimum number of firms. To do this, let us briefly consider a fairly trivial case in

which we retain the assumption of constant returns to scale.

3.

Conditional on n the equilibrium price, outputs and profits will still be given by (11)(14). We assume that firms will enter the market as long as it is profitable to do so,

and will carry on entering up to the point where profits are zero. But then, from ( 14),

with F = 0, it follows that the equilibrium number of firms is .

Optimum Number of Firms

Since, conditioning on n welfare in the equilibrium is still given by (19), it is easy to

(a d ) 2

B , so the market does indeed achieve

see that when n , then B e

2b

the full social optimum.

All that is happening here is that with zero fixed costs so many firms enter the market

that firms are operating essentially under conditions of perfect competition. Each

firms gets infinitesimally small relative to the size of the market and so can exercise

no market power. Thus the forces of free entry produce perfect competition and

hence the social optimum.

A much more interesting case arises when we take increasing returns to scale

seriously and allow the possibility that F > 0.

4.

Equilibrium

When firms are maximising profits it is only marginal costs that matter, so,

conditional on there being n firms in the market, the equilibrium price, output and

profit per firm are once again given by (11) - (14). The crucial difference from before

is that now profits are not always positive. If we assume that firms enter up to the

point where profits are zero, then the equilibrium number of firms is given by

(a d ) 2

1

. e

F

b

(n 1)2

i.e.

(a d ) 2

n Z 1, where Z

.

bF

e

(22)

least one firm in the market. I am going to assume that Z > 9, so that we get at least 2

firms in the market and so have some degree of competition.

Optimum

The first point to notice now is that with positive fixed costs and constant marginal

costs then there is no competitive equilibrium. If price is at or below d then no firm

could enter the market and make a profit, and so supply would be zero. If price is

above d then every firm can anticipate making infinitely large profits by expanding

output indefinitely, so supply would be infinite. There is therefore no price at which

supply equals demand.

The important implication of this is that we can no longer use perfect competition as

a benchmark. So what benchmark can we use to determine the optimum number of

firms?

There are two possible candidates.

1)

Suppose that, whatever the number of firms that enter the market, it is always

possible to ensure that firms produce the first-best optimal output - where p = MC say by the use of regulation. Then, if there n firms in the market, the level of welfare

will now be given by

(a d ) 2

(23)

B

nF

2b

The correct criterion by which to determine the "right" number of firms is simply to

find that number which maximises B as defined by (20). Clearly the optimum is to

make n as small as possible, and so since need at least one firm, first-best optimum is

n 1.

But then the equilibrium number of firms as determined by (22) will, in general, be

greater than the optimal number of firms.

2)

Second Best

Suppose now that the government cannot regulate prices, and that, whatever

number of firms enter the industry, the equilibrium price and output will be given by

equations (11)-(13). In this case the level of welfare if n firms enter the industry is

given by

(a d ) 2

1

Be

. 1

nF

(24)

2

2b

(n 1)

Suppose, however, that the government can restrict entry - what should be the

optimal number of firms ? The optimum is now the number which maximises B e as

defined by (24). The optimum number is then defined by

(a d ) 2

1

.

F

b

(n 1)3

(25)

i.e. we increase number of firms until marginal reduction in dead-weight loss from

having one more firm equals fixed cost of entry.

This implies that the optimal number of firms is given by

n 3 Z 1

(26)

(a d ) 2

Assume that Z

8 , so that it is second-best optimal to have at least 1

bF

firm in the industry, then clearly the equilibrium number of firms as determined by

(22) will once again generally be greater than the optimum.

Hence, whichever definition of the "right" number of firms we use, markets produce

too much entry. This is the EXCESS ENTRY THEOREM and generalises way

beyond the special model used here.

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