internal economics of scale

ECO 441—Spring 2016

Prof. Miguel A. Iraola

Problem Set #3: External and Internal Economies of Scale

(Due date Wednesday, March 28th)

External Economies of Scale

Suppose that there are external economies of scale in the production of motion pictures (films), so that film production is subject to a forward-falling supply curve (downward-sloping industry average cost curve). The graph below shows the industry average cost curves in two countries. Suppose also that the world film industry originated in country A, where all 150 films per year are currently produced. However, as indicated by the graph, the cost of film production is potentially lower in country B due to B’s greater relative endowment of natural artistic talent.

a. Briefly describe (list) two reasons why the film industry might face a downward sloping average cost curve.

b. What prevents individual film producers in Country B from entering the world market, even though the current level of world output could be produced more efficiently if all production was relocated to Country B?

c. Suppose that Country B’s government wants to develop a domestic film industry by temporarily banning imports of Country A’s films. What is the minimum domestic market size (i.e. minimum domestic demand at the current world price) that would be necessary for this policy to foster a globally competitive film industry in Country B (i.e. one that would be more efficient than Country A’s)? Briefly explain how temporary protection of B’s market (e.g. by temporarily banning imports) might improve welfare in both Country B and the world as a whole.

ACA

DWorld ACB

Q (industry # films per year)

$ mill. per film

2

Monopolistic Competition and Intra-Industry Trade Suppose that the market for motorcycles is characterized by monopolistic competition, and that there are FOUR countries (S=40,000) S denotes motorcycles sold. Take the following assumptions as given:

• All firms in each country have identical cost structures and symmetric demand curves, so that they set the same price and share the market equally. Hence each firm sells Si / ni, where ni represents the number of firms in country i and Si denotes the market size in country i.

• The fixed cost of production for a firm in the motorcycle industry is F = $1,000,000 and the variable cost per finished motorcycle (= constant marginal cost) is equal to c = $1,000.

• Under autarky, the market price in each country is given by: Pi = c + 1/(ni/100). a. Calculate the equilibrium number of firms (ni*) in each country’s market without trade. Show

your work and circle your final answer. b. Calculate the autarky equilibrium price of a motorcycle in each country. c. Now suppose that the four countries form a free trade agreement for motorcycles, so that

their markets are completely integrated. Calculate the equilibrium number of firms in the integrated world market (nworld*).

d. Calculate the free trade equilibrium price of a motorcycle. e. Briefly explain why production is more efficient under free trade. Is it related to the

presence of internal economies of scale? f. Are producers in the integrated market making positive profits?