Question

Consider a model of increasing returns to scale with symmetric firms.

a) Algebraically show what the equilibrium number of firms, price, and average cost must be, in terms of their equations. You may start from the equations relating price to the number of firms p=c+1/bn, and average cost to the number of firms AC=Fn/S+c.

B) with the aid of a diagram, illustrate what happens to the equilibrium number of firms, prices, and average cost when one country opens up to trade (integrates its market) with another country. Explain whether consumers in the original country are better off, and specifically how.

C) Assuming we start off in pre-trade equilibrium, what happens in the model when the fixed cost F decreases, in terms of number of firms, prices, and average cost? You can answer this question graphically or with algebra. Would you conclude that consumers are better off, worse off, or uncertain?

Answer 1

a)

b)

Openness to trade increases the total sales and market size in the domestic country, The equilibrium number of firms will increase.

Pirce and Average COst will decrease in the home country and the consumers in the original country are better-off with integration as they pay lower prices and have more options to purchase.

After integration, as shown in figure below, n* > nT and P* < PT

c)

As derived in part a), a decrease in the fixed cost will increase the number of firms. Equilibrium prices will increase as F and P are directly related.

AC (Average Cost) will also increase as both F and AC are directly related with each other.

So, the consumers are worse-off as they now have to pay higher prices for goods and services sold in the market

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