Question

In the increasing returns to scale model, where firms can differ in terms of their marginal cost of production,

a) Explain how you would expect opening up to trade to affect the cutoff marginal cost. Explain also which firms win and which firms lose, specifically making reference to a diagram with the demand curve (and any changes to it) to help you explain your points.

b) Suppose that the rise of Chinese import competition leads to an increase in competition, but no corresponding increase in market size for firms. How would this affect the cutoff marginal cost, as well as the operating profits of different firms (with different marginal cost)?

Answer 1

a)Marginal Cost- First of all lets understand what is marginal cost, It is the cost that occurs when producing one more unit of good. As we all know MC=TCñ-TCñ-1 .So that means if one wants to control the cost of production , a producer has to lower the one unit cost of production to earn maximum output.
So as per the question , if one wants to cut off the trade cost , one needs to lower down the marginal cost of production. Also keeping MC =MR would make producer earn maximum profit.

b)Yes, thats true Chinese exports leads to increase in the market competition but no increase in the corresponding size of firms. Firms are still able to cope up with the competition only because of product differentiation. When the products differ in terms of quality, features it attracts consumers.It also leads to innovation ,inventions of new product in the market thus firms are able to earn profits even when there is import competition.