Question

Assume that firms in the automobile industry face the following price function

P = 12 000 + (1000/n)

where P is the equilibrium unit price a single firm demands and n denotes the number of firms that operate in the market. The average cost each firm faces is

AC = 50 000 x (n/S) + 12 000

where n denotes again the number of firms that operate in the market and S is the market size (i.e., the total number of automobiles that is produced).

a) How does an increase in the number of firms (i.e., an increase in n) affect the price (P) and the average cost (AC), respectively?

b) Assume that the initial size of the automobile market in the US is 450 automobiles and for Canada it is 200 automobiles, respectively. The industries are closed for trade.

b1) Calculate the equilibrium number of firms (n) in the US and Canada, respectively. Provide intermediate steps of your calculations.

b2) What is the equilibrium price of automobiles in the US and Canada, respectively? Round your result to 2 decimal places.

c) Now suppose that there is a free trade agreement so that the markets in the US and Canada become an integrated market of size S = 650.

c1) How many automobile firms will there be in the integrated market in equilibrium? Provide intermediate steps of your calculation and round your result to 2 decimal places.

c2) What is the new equilibrium price of automobiles? Round your result to 2 decimal places.

c3) Based on your previous results, give two arguments why consumers are better off with trade in the given context of monopolistic competition.

d) A study by Trefler (2004) finds that the Canada-US Free Trade Agreement in 1989 increased Canada’s industry-level labor productivity by 15%. Briefly explain these findings in the context of monopolistic competition with heterogenous firms (i.e., firms that differ with respect to their productivity).

Answer 1