Imperfect Competition, Increasing Returns, etc.For a larger increase in than in part (a), will extend AC to the right beyond DW. This means that equilibrium is found in the interior of AC, and that the Home country now produces both goods. The relative price of M still falls, and indeed by more than in part (a). Now the output of both goods rises in Home, and since the output of F in Foreign remains unchanged, the world outputs of both goods also rise. Welfare effects are almost the same as before, with Home probably losing and Foreign certainly gaining. However the Home PPF diagram looks somewhat different since it now produces some F and the price equals its average cost.South’s increased productivity turns it into an exact replica of North, with PPF . The two countries are now identical in all respects, and they will not trade, reverting instead to the autarky equilibrium A*. Thus, while South gains a huge amount, due to its threefold productivity improvement, North actually loses a small amount. That is, it loses what had been its gains from trade, since it no longer has anybody different than it to trade with.Econ 441 Alan DeardorffProblem Set 5 - Answers Imperfect Competition, Increasing ReturnsPage 1 of 10Problem Set 5 - AnswersImperfect Competition, Increasing Returns, etc.1. Consider a monopolist in partial equilibrium who initially faces the demand curve D1 shown below, and whose marginal cost is constant at c.a. Construct the profit-maximizing equilibrium for this monopolist.This is found from the marginal revenue curve, MR1, drawn as the straight line half the distance between the vertical axis and the demand curve D1. Where thatMR1 curve cuts the marginal cost line, c, determines the output Q1 that the monopolist will produce. Vertically above that on the demand curve is the price,p1, that will clear the market at that quantity, and p1 is therefore the price that the monopolist will charge. p Q D1 MR1 Q1 p1 c p Q D1 cEcon 441 Alan DeardorffProblem Set 5 - Answers Imperfect Competition, Increasing ReturnsPage 2 of 10b. Suppose now that the demand curve becomes everywhere more elastic, but continues to pass through the same price-quantity point that you found to be optimal in part (a). (That is, if the profit-maximizing monopolist was producing Q1 and selling it for p1 in part (a), quantity Q1 still has price p1 on the new, more elastic, demand curve.) Construct the new equilibrium for the monopolist and compare it to the old, in terms of quantity, price, and profit.Becoming more elastic, the demand curve rotates counter-clockwise through point A. The new marginal revenue curve, being half the distance between the vertical axis and this new curve, intersects MR1 directly to the left of A, since this point is half way between the axis and both curves. It therefore must lie to the right of MR1 everywhere below p1, and from this it follows that it crosses thec line at some Q2>Q1. From the new demand curve, then, it is also true that p2<p1, as shown.Thus quantity rises and price falls, due to this particular change in the demand curve. Profit, which was (p1–c)Q1 and is now (p2–c)Q2, may seem at first to be ambiguous in its change, since the markup falls but the quantity rises. However, the firm could continue to produce Q1 and charge p1 if it wanted to, and that would give it the same profit as before. Since it chooses instead to increase output, this must be because that yields it a larger profit. So we can besure, after all, that profit rises in this case.c. Explain what your answer to part (b) could have to do with international trade.This exercise is relevant to international trade because in general the opening totrade causes firms to face more elastic demand, due to the competition from foreign suppliers. If competition is great enough, demand elasticity would become infinite, which is more extreme than shown above. But even with just a few additional competitors, switching from a monopoly to a duopoly or oligopoly, the elasticity faced by the firm will increase. Now whether it will rotate around the particular point shown above is another question. So all that p Q D1 MR1 Q1 p1 D2 MR2 p2 Q2 c AEcon 441 Alan DeardorffProblem Set 5 - Answers Imperfect Competition, Increasing ReturnsPage 3 of 10we can really take from this example that may be general is that the price (and thus the markup) will fall, just as we saw from the algebra in class.2. Explain why the gains from trade with imperfect competition may be larger than they are with perfect competition. Does it therefore follow that, if a country is going to trade in any case, then it would be better off if its industries were imperfectly competitive instead of perfectly competitive, so as to enjoy those larger gains? Explain and illustrate using production possibility frontiers and community indifference curves.The gains from trade with imperfect competition include the “pro-competitive gains” that arise when imperfectly competitive firms reduce their markups over marginal cost – markups that cause imperfect competition to be less than optimal. That is, the increased competition from foreign firms reduces the dead-weight loss due to monopoly and other imperfectly competitive behavior. This reduction in deal-weight loss is then added to whatever gain from trade would otherwise arise if the firms were already competitive, yielding a larger gain from trade.No, it does not follow that a trading country is better off having imperfectly competitive firms. The converse is true, however: that a country with imperfectly competitive firms is better of trading, since trade reduces the costs to it of the imperfect competition.To illustrate, consider the three graphs below showing PPFs and three different possibilities for the world price. In each case, as in the text, good X is produced by a monopolist that charges a markup over cost in autarky, but becomes a price taker under free trade. In autarky, therefore, the relative price of X to consumers is higherthan the slope of the PPF, at points B in each diagram. If there were no monopoly, and also no trade, the country would produce and consume at point A, reaching utility uA. But the monopoly lowers autarky utility to uB. Y X A B uA uB C P Y X A B uA uB C P Y X A B uA uB C P p1* uC uC p2* p3* uCEcon 441 Alan DeardorffProblem Set 5 -