The Economics of European Integration Chapter 6 : Market Size and Scale Effects

1. The Economics of European IntegrationChapter 6:  Market Size and Scale Effects Interactive Presentation for Teaching/Studying • Monopoly diagram • ICIR Diagram • No-trade-to-free-trade liberalisation (Positive and Welfare) INSTRUCTIONS: To view this, start the slide show (‘view show’ command under the Slide Show pull-down menu) and use either the arrow keys or click the mouse to proceed. NB: this is not designed to be printed out; view it on a computer.

2. Imperfect Competition and Increasing Returns To understand why market size matters, we need to enrich the highly simplified framework employed in Chapters 4 and 5. The key new elements are increasing returns to scale and imperfect competition since these allow us to connect firm size to efficiency. In fact, we need a simple yet flexible framework that allows for imperfect competition. The framework we employ below – the BE-COMP diagram – assumes a knowledge of simple imperfect competition models. We start, therefore, with an introduction to the simplest forms of imperfect competition, namely monopoly, duopoly and oligopoly. As usual, we follow the principle of progressive complexity. This means starting with the simplest of all imperfect competition frameworks -- monopoly.

3. Monopoly Problem The monopoly problem is the easiest of all imperfection competition framework because the monopolist does not have to worry about the behaviour of competing firms. Nevertheless, it turns out that the basic insights that arise from a careful study of the monopolist problem carry over directly to more sophisticated frameworks. For this reason, we work through the monopolists problem carefully, stressing the general lessons.

4. Monopoly Problem The profit-maximizing monopolist’s problem is to decide how much to sell and what price to charge (these problems are related due to the demand curve – the amount that can be sold depends upon the price charged). Demand Curve Here, the monopolist faces a dilemma. Selling more tends to raise the firms revenue and this boosts profits, but to get consumers to buy the extra units, the monopolist must lower prices and this is bad for profits. Euros Marginal Cost Curve P’ A P” To find the profit-maximizing level of sales, we will make a guess and then see whether profits rise or fall when we modify our initial guess B D C E Q’ Q’+1 Sales

5. Monopoly Problem Let’s guess that Q’ is the profit maximizing level of sales and P’ is the corresponding price (given the demand curve, we could just as well have said P’ was our guess for the profit maximizing price and Q’ was the implied level of sales). Demand Curve At Q’, P’ the firm has revenue equal to the areas A+B+C (this equals the price times the sales). Its costs, assuming that it has flat marginal costs as shown, are just the area C (this is the marginal cost times sales). Euros Marginal Cost Curve P’ A The profit is the difference between revenue and cost. This equals areas A+B when Q’ is chosen. B C Q’ Sales

6. Monopoly Problem Now ask yourself, is Q’ the best the monopolist could do? An excellent way to address this question is to see what would happen to profits, if the firm sold one more unit. Demand Curve If Q’+1 is to be sold, the maximum price the firm can charge is P”. At this price and sales level, the firm has revenue equal to the areas B+C+D+E (this equals the price, P”, times the sales Q’+1). The costs at this level of output are C+E. Euros Marginal Cost Curve (MC) P’ A As always, profit is the difference between revenue and cost. This equals areas B+D when Q’+1 is chosen. P” B D C E Q’ Q’+1 Sales

7. Monopoly Problem The loss, A, is just the necessary price drop (from P’ to P”) times that number of units that used to be sold at the higher price, namely Q’. The gain is the new unit sold times the new price, P”. So which level of output implies a higher profit? With a bit of thought, you should be able to see that the answer can be found by thinking about the change in the revenue and the change in the costs. Specifically, if selling one more unit raised revenue by more than it raised costs, then profits are higher under Q’+1 DemandCurve Euros P’ A The change in marginal revenue is plus D and E minus A. That is … P” B D MC C E Q’ Q’+1 Sales

8. Monopoly Problem As the diagram is drawn, it looks like selling one more unit lowers profits The reason is that the change is revenue is quite small; as drawn, it looks like area A is a little bit bigger than D so revenue increases by less than E. However, costs go up by E, so the rise is costs exceeds the rise in revenue. DemandCurve Euros P’ This suggests that we should check whether reducing Q’ by one unit would raise profits. This method, however, is extremely slow. We turn now to a more convenient way of finding the profit maximizing level of sales … A P” B D MC C E Q’ Q’+1 Sales

9. Monopoly Problem D1+ D2+E-A The trick is to show how ‘marginal revenue’, i.e. the extra revenue from an extra sale, varies with Q. The right diagram plots two points; the marginal revenue at Q’ and at Q’+1. The ‘Marginal Revenue curve” shows what the plot of all such points would look like. It should be clear that this new curve is downward sloped because each time the extra unit sells for less AND because the necessary price drop affects more sales. Demand euros Euros Marginal Revenue Curve F+G-B1-D1 P’ A P” B1 D1 P’” B2 F D2 MC MR G C E Sales Q’ Sales Q’ Q’+1 Q’+1 Q’+2