Question

Suppose the fixed costs for a firm in the automobile industry are $7.5 billion and the variables costs are $20,000 per automobile. As more firms increase competition in the market, the market price decreases with an increase in the number of firms, i.e., P=20,000 + (200/n) where n is the number of firms in the market. Suppose that the size of the US and the European automobile markets are 400 million and 650 million, respectively.

a. Calculate the equilibrium number of firms in the US and European automobile markets without trade. (hint: the equilibrium number of firms can be determined by setting average cost equal to price)

b. Calculate the equilibrium price of automobiles in the US and Europe if the automobile industry does not engage in foreign trade?

c. Suppose now the US decides on free trade in automobiles with Europe. The trade agreement with Europe adds 650 million consumers to the automobile market, in addition to the 400 million in the US. What would be the new market size after trade.

d. In part c above, what will be the new equilibrium price of automobiles?

Answer 1

B) autarky prices

In US, P = 20,000 + 200/3

= 20,066.67

In Europe, P = 20,000 + 200/4

= 20,050

C) integrated market size = 650+400 = 1050 million

d) now at eqm in integrated market

200/n = 7500n/ 1050

So n^{​​​​​​2}​​​ = 28

So number of firms in integrated market n* = 5

so new price = 20000 +200/5

= 20,040