University of Papua New Guinea International Economics Lecture 10: Firms in the Global Economy...
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Transcript of University of Papua New Guinea International Economics Lecture 10: Firms in the Global Economy...
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University of Papua New Guinea
International Economics
Lecture 10: Firms in the Global Economy [Internal Economies of Scale]
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The University of Papua New GuineaSlide 2
Lecture 10: Firms in the Global Economy Michael Cornish
Overview
• Introduction
• Monopolistic competition: A review
Internal Economies of Scale:
• Setting up the model
• Adding in the trade
• Conclusions
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The University of Papua New GuineaSlide 3
Lecture 10: Firms in the Global Economy Michael Cornish
Introduction
• A few lectures ago we talked about internal and
external economies of scale…
• External economies of scale occur when the
cost per unit of production depends on the size
of the industry, but not necessarily on the size
of any one firm
» [See: Lecture 8]
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The University of Papua New GuineaSlide 4
Lecture 10: Firms in the Global Economy Michael Cornish
Introduction
• Internal economies of scale occur when
the cost per unit of production depends on
the size of an individual firm, but not
necessarily the size of the industry…
»Today’s lecture!
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The University of Papua New GuineaSlide 5
Lecture 10: Firms in the Global Economy Michael Cornish
Introduction
• Internal economies of scale could take the
form of three possible structures:
1. Monopoly
– ‘Pure’ monopoly is unlikely in global markets
2. Oligopoly
– Pricing strategy depends on the choices of
other firms => requires game theory!
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The University of Papua New GuineaSlide 6
Lecture 10: Firms in the Global Economy Michael Cornish
Introduction
3. Monopolistic competition
– Pricing strategy does not depend on other firms
– Empirical evidence shows that this is by far the
most common form of global market structure
– So this is what we will concentrate on!
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The University of Papua New GuineaSlide 7
Lecture 10: Firms in the Global Economy Michael Cornish
Monopolistic competition: A review
Characteristic Monopolistic competition
Number of firms Many
Type of product Differentiated
Barriers to entry/exit Low
Price taker / maker? Taker
Classic examples of industries
• Hairdressers• Restaurants
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The University of Papua New GuineaSlide 8
Lecture 10: Firms in the Global Economy Michael Cornish
Monopolistic competition: A review
• Lots of firms, price-taking… so how is it
different from perfect competition?
• Because of product differentiation, each firm
in monopolistic competition faces their own
downwards-sloping demand curve…
– And thus a downwards sloping MR curve!
– As usual, profit maximisation occurs in
accordance to where MC = MR
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The University of Papua New GuineaSlide 9
Lecture 10: Firms in the Global Economy Michael Cornish
Price (and revenue)
Quantity
Demand = average revenueMarginal
revenue0
To sell more, the price must be lowered.
Thus the marginal revenue curve will be below the demand curve.
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The University of Papua New GuineaSlide 10
Lecture 10: Firms in the Global Economy Michael Cornish
Monopolistic competition: A review
Costs:
• Economies of scale means we have a
downwards sloping average total cost (ATC)
curve
• We assume that the economies of scale
come from the fixed production cost being
distributed across more units of production
• This means marginal cost is constant!
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The University of Papua New GuineaSlide 11
Lecture 10: Firms in the Global Economy Michael Cornish
Monopolistic costs
Note:The numbers are not
important: what is important is that MC is
constant, and ATC is asymptotic
ATC = average total cost = AC = average cost [Note: these are all the same!]
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The University of Papua New GuineaSlide 12
Lecture 10: Firms in the Global Economy Michael Cornish
Putting revenue and costs together: Monopolistic pricing
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The University of Papua New GuineaSlide 13
Lecture 10: Firms in the Global Economy Michael Cornish
Internal economies of scale: Setting up the model
• Two key assumptions that allow us to adopt
monopolistic competition as our market
structure of analysis:
1. Firms can differentiate their products
– Firms have some level of monopoly in
their specific product
– …meaning that competition is not highly
price sensitive
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The University of Papua New GuineaSlide 14
Lecture 10: Firms in the Global Economy Michael Cornish
Internal economies of scale: Setting up the model
2. Firms take the prices of its rivals as a
given
– I.e. the firm ignores the impact of their own
prices on competitors
– In this way, the firm acts like a monopolist…
hence the name, monopolistic competition!
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The University of Papua New GuineaSlide 15
Lecture 10: Firms in the Global Economy Michael Cornish
Internal economies of scale: Setting up the model
The equation for an individual firm’s supply curve:
QFirm = QIndustry * [(1/n) – b * (P – )]
Where:
n = number of firms in the industry [1/n is market share]
P = price charged by our chosen firm
= the average price charged by competitors
b = a constant to reflect the responsiveness of the
firm’s sales to price
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The University of Papua New GuineaSlide 16
Lecture 10: Firms in the Global Economy Michael Cornish
• This equation means that a firm that
charges a high price will have a smaller
market share, and vice versa
• Now we need to find the market
equilibrium
– And for this we need to find out what n
and are…
Internal economies of scale: Setting up the model
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The University of Papua New GuineaSlide 17
Lecture 10: Firms in the Global Economy Michael Cornish
Internal economies of scale: Setting up the model
1. The number of firms determines average costs
• If all the firms were identical:
QFirm = QIndustry/n
• Thus:
ATC = FC/QFirm + MC = [n * (FC/QIndustry)] + MC
Where:
• FC = fixed cost; MC = marginal cost
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The University of Papua New GuineaSlide 18
Lecture 10: Firms in the Global Economy Michael Cornish
Internal economies of scale: Setting up the model
• What does that equation tell us?
– The more firms there are in the
industry, the higher the average cost
– Which just reflects what we understand
about economies of scale!
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The University of Papua New GuineaSlide 19
Lecture 10: Firms in the Global Economy Michael Cornish
Internal economies of scale: Setting up the model
2. The number of firms determines the price
Markup over marginal cost = (P – MC)
(P – MC) = 1 / (b * n)
• How did we end up with these equations??
– You can follow the algebraic proofs in
Chapter 8, p161-163 of the textbook notes
– But you won’t be tested on the proofs!
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The University of Papua New GuineaSlide 20
Lecture 10: Firms in the Global Economy Michael Cornish
Internal economies of scale: Setting up the model
• What does this second equation tell us?
– The more firms there are in the
industry, the lower the price they
charge
– Which just reflects what we understand
about economies of scale when we have
competitive pricing!
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The University of Papua New GuineaSlide 21
Lecture 10: Firms in the Global Economy Michael Cornish
Internal economies of scale: Setting up the model
• Ok, let’s put our conclusions about costs and
prices together!
1. CC: The more firms there are in the industry,
the higher the average cost
2. PP: The more firms there are in the
industry, the lower the price they charge
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The University of Papua New GuineaSlide 22
Lecture 10: Firms in the Global Economy Michael Cornish
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The University of Papua New GuineaSlide 23
Lecture 10: Firms in the Global Economy Michael Cornish
Explanatory note for previous slide...
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The University of Papua New GuineaSlide 24
Lecture 10: Firms in the Global Economy Michael Cornish
Internal economies of scale: Adding in the trade
• Adding trade into the model has a simple
effect:
– It increases the size of the market
(QIndustry)
– …and increases the number of firms!
(n)
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The University of Papua New GuineaSlide 25
Lecture 10: Firms in the Global Economy Michael Cornish
Internal economies of scale: Adding in the trade
• Using our formula for ATC again:
ATC = [n * (FC/QIndustry)] + MC
• We see that if we increase the size of the
market (QIndustry), ATC goes down for any
given number of firms (n)
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The University of Papua New GuineaSlide 26
Lecture 10: Firms in the Global Economy Michael Cornish
Internal economies of scale: Adding in the trade
• However, using our price formula (markup
formula):
(P – MC) = 1 / (b * n)
Rearranged: P = MC + [1 / (b * n)]
• …we see that the size of the market (QIndustry),
is not relevant at all to the price charged by
firms!
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The University of Papua New GuineaSlide 27
Lecture 10: Firms in the Global Economy Michael Cornish
Internal economies
of scale: Opening to
trade
Note:As discussed, QIndustry leads to lower costs (for any given
n), and no change in the price charged (for any given
n)
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The University of Papua New GuineaSlide 28
Lecture 10: Firms in the Global Economy Michael Cornish
Conclusions
• This combining of domestic markets into
one global market is called market
integration
• Who loses out?
– Some firms are kicked out of the market
– Ambiguous effect on total employment
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The University of Papua New GuineaSlide 29
Lecture 10: Firms in the Global Economy Michael Cornish
Conclusions
• But everyone else is definitely better off a
result of market integration:
– Costs are lower => remaining firms are
happy!
– Prices are lower => consumers happy!
– More total product differentiation =>
consumers happy again!
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The University of Papua New GuineaSlide 30
Lecture 10: Firms in the Global Economy Michael Cornish
Conclusions
• Trade due to consumer demand for product
differentiation is called intra-industry trade
– I.e. Germans buy Porsches from Italy,
Italians buy Mercedes from Italy…
• Intra-industry trade has grown significantly
since World War II