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Imperfect Competition

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Prepared by Iordanis Petsas To Accompany International Economics: Theory and Policy, Sixth Edition Policy by Paul R. Krugman and Maurice Obstfeld

Chapter Organization

Introduction Economies of Scale and International Trade:

Overview Economies of Scale and Market Structure The Theory of Imperfect Competition Monopolistic Competition and Trade Dumping The Theory of External Economies External Economies and International Trade Summary An

Slide 6-2

Introduction

Countries engage in international trade for two basic

reasons:

resources or in technology. Countries trade in order to achieve scale economies or increasing returns in production.

of scale and imperfect competition play a crucial role:

Slide 6-3

Models of trade based on comparative advantage (e.g.

Ricardian model) used the assumptions of constant returns to scale and perfect competition:

production of any commodity will increase output of that commodity in the same proportion.

it takes place.

Slide 6-4

Under increasing returns to scale:

Output grows proportionately more than the

increase in all inputs. Average costs (costs per unit) decline with the size of the market.

Slide 6-5

Economies of scale can be either:

External

The cost per unit depends on the size of the industry but not necessarily on the size of any one firm. An industry will typically consist of many small firms and be perfectly competitive.

Internal

The cost per unit depends on the size of an individual firm but not necessarily on that of the industry. The market structure will be imperfectly competitive with large firms having a cost advantage over small. Both types of scale economies are important causes of international trade. Slide 6-6

Revising Microeconomics

Imperfect competition

Firms are aware that they can influence the price of

their product. (Price Setter)

They know that they can sell more only by reducing their price.

is that of a pure monopoly, a market in which a firm faces no competition.

Slide 6-7

Revising Microeconomics

Imperfect Competition: A Brief Review

Marginal revenue

The extra revenue the firm gains from selling an additional unit Its curve, MR, always lies below the demand curve, D.

Slide 6-8

Figure 6-1: Monopolistic Pricing and Production Decisions

Cost, C and Price, P Monopoly profits PM AC AC MC MR QM Quantity, Q

Slide 6-9

Revising Microeconomics

Assume that the demand curve the firm faces is a straight line: Q=ABxP Then the MR that the firm faces is given by: MR = P Q/B (6-1)

(6-2)

Slide 6-10

Q=ABxP P=A/B -1/B x Q TR=P x Q=(A/B -1/B x Q) xQ TR=A/B xQ -1/B x Q2

Differentiate the TR with respect to the Q gives MR. MR=d (TR)/ dQ = A/B-2/B x Q MR=(A/B -1/B x Q) - 1/B x Q MR=P- Q/B

Slide 6-11

does the revenue increase by if the Quantity Q increases say by dQ TR` is the Revenue when Q +dQ is produced. Just substitute Q+dQ in place of Q in TR function. Then MR = (TR`-TR)/Dq TR=A/B xQ -1/B x Q2 & (P=A/B -1/B x Q) TR`=A/B (Q+ dQ) (Q+dQ)2/B TR`=(A/B x Q -1/B x Q2)+ (A/B xdQ)-(1/B x (dQ)2)-(2/B x Q x dQ) TR`=TR + (A/B -1/B x Q) x dQ -1/B x Q x dQ+1/B x (dQ)2 TR`=TR + P x dQ -1/B x Q x dQ=TR + (P -1/B x Q) x dQ (TR`-TR)/dQ = P -1/B x Q MR=P-Q/B

Slide 6-12

Revising Microeconomics

Average Cost (AC) is total cost divided by output. Marginal Cost (MC) is the amount it costs the firm to produce

one extra unit. When average costs decline in output, marginal cost is always less than average cost. Suppose the costs of a firm, C, take the form: C=F+cxQ (6-3)

This is a linear cost function. The fixed cost in a linear cost function gives rise to economies of scale, because the larger the firms output, the less is fixed cost per unit.

AC = C/Q = F/Q + c (6-4)

Slide 6-13

Figure 6-2: Average Versus Marginal Cost

Cost per unit 6 5 4 3 2 1 0 2 4 6 8 Marginal cost 10 12 14 16 18 20 22 24 Output

Slide 6-14

Average cost

Try it at home

Suppose the costs of a firm, C, take the form:

C = F + c x Q - Q2

AC = C/Q = ? MC=dC/dQ=?

Slide 6-15

differentiated products. Two key assumptions

Each firm is assumed to be able to differentiate its product from its rivals. Each firm is assumed to take the prices charged by its rivals as given.

We expect a firm:

To sell more the larger the total demand for its industrys product and the higher the prices charged by its rivals To sell less the greater the number of firms in the industry and the higher its own price

Slide 6-16

Monopolistic Competition

Oligopoly

Internal economies generate an oligopoly market structure.

There are several firms, each of which is large enough to affect prices, but none with an uncontested monopoly.

world?

Some industries may be reasonable approximations (e.g., the automobile industry in Europe)

Also, there are lots of monopolies in the Chemical Industry.

Case Study of the Chemical Industry.

Each firm decides its own actions, taking into account how that decision might influence its rivals actions.

Slide 6-17

Slide 6-18

Slide 6-19

Slide 6-20

Slide 6-21

A particular equation for the demand facing a firm

that has these properties is: Q = S x [1/n b x (P P)] (6-5)

where:

Q is the firms sales S is the total sales of the industry n is the number of firms in the industry b is a constant term representing the responsiveness of a

firms sales to its price P is the price charged by the firm itself P is the average price charged by its competitors

Slide 6-22

Market Equilibrium

All firms in this industry are symmetric

The demand function and cost function are identical for all firms.

The method for determining the number of firms and the average price charged involves three steps:

We derive a relationship between the number of firms and the average cost of a typical firm. We derive a relationship between the number of firms and the price each firm charges. We derive the equilibrium number of firms and the average price that firms charge.

Slide 6-23

The number of firms and average cost

How do the average costs depend on the number of firms in the industry? Under symmetry, P = P, equation (6-5) tells us that Q = S/n but equation (6-4) shows us that the average cost depends inversely on a firms output. We conclude that average cost depends on the size of the market and the number of firms in the industry: AC = F/Q + c = n x F/S + c (6-6)

The more firms there are in the industry the higher is the average cost.

6.5 Q = S x [1/n b x (P P)]

Slide 6-24

The number of firms and the price

The price the typical firm charges depends on the number of firms in the industry.

The more firms, the more competition, and hence the lower the price.

In the monopolistic competition model firms are assumed to take each others prices as given. If each firm treats P as given, we can rewrite the demand curve (6-5) in the form: Q = (S/n + S x b x P) S x b x P (6-7)

6.5 Q = S x [1/n b x (P P)]

Slide 6-25

Profit-maximizing firms set marginal revenue equal to their marginal cost, c. Demand: Q = (S/n + S x b x P) S x b x P

When demand is Q = A B x P Then the MR is: MR = P Q/B

MR=P-[1/(S xb)]Q

Given Q = S/n

MR=P- 1/(b x n) MR=MC P- 1/(b x n)=c This generates a negative relationship between the price and the number of firms in the market which is the PP curve: P = c + 1/(b x n) (6-10)

The more firms there are in the industry, the lower the price each

firm will charge.

Slide 6-26

Figure 6-3: Equilibrium in a Monopolistically Competitive Market

Cost C, and Price, P AC3 P1 P2, AC2 AC1 P3 CC E

PP

n1

n2

n3

Number of firms, n

Slide 6-27

The equilibrium number of firms

The downward-sloping curve PP shows that the more firms, the lower the price each firm will charge.

The more firms, the more competition each firm faces.

The upward-sloping curve CC tells us that the more firms there are, the higher the average cost of each firm.

If the number of firms increases, each firm will sell less, so firms will not be able to move as far down their average cost curve.

Slide 6-28

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