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Economies of Scale
Oligopolies with homogenous products
Competitive effect of trade
Cournot duopoly
Dumping, strategic subsidies and investments
Pass-through
1. Definition
2. Example
Outline
3. External scale economies
4. Internal scale economies
4.1 What is the difference between external scale
economies and internal scale economies?
5. Cournot oligopolies
5.1 Assumptions
5.2. Trade opportunities and competitive effect of trade
5.3. Dumping
5.3.1 Definition
5.3.2 What are the conditions for the existence of dumping?
5.3.3 What happens when a firm in monopolistic position
on the domestic market begins to export somewhere else?
A) Increasing marginal costs.
B) Constant marginal costs.
5.3.4. Anti-dumping interventions
5
7
13
2
Outline Cont.
5.4. Price and quantity produced by the Duopoly?
5.4.1. Assumptions: Cournot-Nash
5.4.2. Demand for homogenous goods
5.4.3. Firms profit maximization
5.4.4. Reaction functions of firms
5.4.5. Duopoly as contestation of Monopoly
5.4.6. Duopoly pricing
5.4.7. Duopoly and Monopoly: profit, price, quantity
23
5.5 How can two monopolistic companies practice reciprocal dumping?30
5.5.1 Assumptions
5.5.2 How do firms chose their production levels?
5.5.3 Partial equilibrium welfare effect
37
5.5.4. How is the local firm going to react?
5.5.5. How can the government react?
3
Outline Cont.
5.6. Exchange rate: “pass through”.
49
6. Differentiated products
see next set of slides
4
4. Internal Scale Economies
4.1. Internal scale economies : Introduction
Under internal scale economies the price and production costs depend on
the behavior of a single firm. Firms increase their efficiency as its own
output increases.
Internal economies of scale leads to creation of big companies which lead
to imperfect competition conditions.
In the following sections we will study the following cases:
• Monopoly power (4.2.).
• Homogenous products (section 5)
-Cournot oligopolies and competitive effect of trade,
-Cournot Duopoly,
-Dumping,
-Reciprocal dumping.
• Differentiated products (section 6)
5
4.1 Monopoly power : the difference between external scale
economies and internal scale economies
The existence of external scale economies leads firms to behave as if
they were in perfect competition. Most of the gains of external scale
economies will be captured by consumers through low prices, as
each company ignores the potential of the scale economy and prices
goods at its perceived marginal cost. External scale economies are
not individually appropriated.
However under the existence of internal scale economies firms are
aware of their condition and will influence prices of the goods they
produce. Quantities will be set to equal marginal cost to marginal
revenue (instead of to price). Prices will be on the demand curve
and may be higher or lower than average cost. Compared to perfect
competition, monopolies reduce quantities to raise prices.
6
5. Cournot oligopolies
5.1 Assumptions of Cournot oligopolies
•Homogeneous products.
• Quantities of competitors are taken as given and each firm behaves as a
monopoly on “residual” demand curve (and residual marginal revenue
curve).
• Each firm maximizes its profits by choosing its own quantity.
One sectors’ high profits attract competition, that’s why under the
existence of internal scale economies the most usual structure of the
sector is oligopoly. Under oligopoly every firm can affect prices.
7
5.2. Cournot Pricing and the competitive effects of trade
5.2.1. Maximization of profits problem:
 I

Maxq  : p  qi qi  C qi 
 i 1 
where i is the number of firms: i = 1,…,I.
I
Q   q i measures the market reaction.
i 1
Market share can be define for all producers as follows: mi 
Q p
p
The price elasticity is:  q  p Q
First order condition:
FOC
qi
Q

p
C

q i  p Q  
0
q i
Q
q
MR(qi,Q) = MC(qi)
8
5.2.2. Oligopoly pricing
From the FOC, then:
 p q Q
 C

 1  
p
 Q p Q
 q
 m

pm i
i








p
1  MC
p MC
p
p


q
q


m
p  MC

 pi
q
p
The margin charged by the firm over the marginal cost is a function of
the market share and the demand elasticity.
9
• The higher the demand elasticity to prices the harder it is to increase
prices.
p
 
 1
 0
Q
At some point, further price increases would reduce quantities too much.
10
• The higher the market share the easier it is to the firm to increase
prices:
• If mi=1 the firm has a monopoly.
• If n is the number of local firms, all firms will be identical if:
1
n
Q
qi 
n
mi 
•The lower the MC, the higher the market share :

m
p  MC
 pi
q
p
11
5.2.3. Trade opportunities and competitive effect of trade
Trade opportunities?
Under external competition the market share of each firm is smaller
and the prices are closer to marginal cost.
If n is the number of domestic firms and n* is the number of foreign
1
firms, then the market share is smaller:
mi 
n  n*
p  MC
p
Big winners: Consumers!!!
Gain from trade :
competition increases
12
5.3 Dumping
5.3.1 Definition
1. Definition
2. Condition of existence
3. A. Effects if MC increasing
B. Effects if MC constant
4. Anti-dumping interventions
Dumping takes place when a firm sells at a lower price in the foreign
market than in the domestic market.
5.3.2 What are the conditions for the existence of dumping?
• Markets must be segmented. It is necessary that goods can not be
traded back from the foreign market to the local market.
• Imperfect competition in the domestic market: there must be barriers
to enter that enables the possibility of local competition.
As we have seen the monopolistic firms fix their prices relative to the
demand elasticity of the market. Whenever the demand they confront in
a foreign market is sufficiently elastic, the firm will be ready to reduce
it’s prices to gain market share.
13
5.3.3 Price and output behavior of a domestic monopolist starting to
export (and go for dumping)
A) Case 1 : Marginal costs are increasing and foreign demand is very
elastic. Then, the domestic consumers act as subsidizers of the
monopolistic company exports.
B) Case 2 : marginal costs are constant and the firm has also an
oligopolistic position in the foreign market. Then, dumping only
produces loses to foreign producer (foreign producer facing
duopoly instead of monopoly position clearly loses). While it
produces gains to foreign consumers and domestic producers,
without affecting local consumers.
In both cases it is the possibility of charging different prices on each
market and that gives rise to trade (exploiting different demand
elasticities: possibility to sell some output on foreign market
without letting prices go down as fast as to sell it on home market).
14
A) Increasing marginal costs, infinite elasticity of foreign demand.
The monopolistic firm maximizes it’s profit that reflects the segmentation
of both markets and the transport costs:
Maxq, q * : pQq  p * Q *q * Cq  q *  t q *
where: q and q* represent the quantities sold in domestic and foreign market.
Q and Q* are total demands.
p and p* are the prices.
t are the transport costs (here assumed t=0).
15

 0  MRq   MC q  q *
The first order conditions are:
q

 0  MR * q *  MC q  q *  0
q *
Then, the condition that the firms needs to satisfy is: MR  MR*  MC
Initially the firm will sell qM at the price pM in the domestic market and
q* at the price p* in the foreign market.
But at this stage the firm can increase their profits if it reduces the
quantity sold in the local market and increase the quantity sold in the
foreign market, this last one at the price p*  MR*  MC
16
Prices
MC
p
pM
p*
D*  MR *
B
C
M
D
MR
O
q
q  q*
qM
Quantity
q*
17
For any quantity higher than q the marginal revenue in the local market
is lower than the marginal revenue in the foreign market.
Then, the firm will reduce the quantity sold in the domestic market from
qM to q. All theses products that pass to be sold in the foreign market
produce a net revenue loss represented by
, but that is more than
compensated by the gains that the monopolistic firm has from selling
the rest of the goods at a higher price in the domestic market. This is
represented by
.
The firm gains from reducing the quantity sold in the domestic market,
and practicing dumping, as p > p*.
The total production of the firm will be q+q*, a higher output could
only be sold at prices lower than the marginal costs.
18
Which are the welfare effects?
Consumers in the domestic market are the big losers. The increase in
domestic market’s prices and decreased in quantity act like a subsidy to
the monopolistic firm. The painted area represents a transfer from
consumers to producers.
The domestic producer has a net gain produced from the diversion of
goods from the local market to the foreign market, and the profit
represented by new products sold in the foreign market.
However, the firm has an opportunity cost from selling abroad. In the
segment Oq, the best market to sell it’s good is the domestic one. And,
from q to q+q*, the production will be sold in the foreign market.
In the foreign market, neither producers nor consumers are affected by
the dumping as the demand has perfect elasticity.
If there was perfect competition, other firms could access to the local market
destroying the monopolistic position of the local firm.
The risk of rising local market’s competition arises from the fact that foreign
companies could also practice dumping on their external markets giving rise to
reciprocal dumping.
19
B) Constant marginal costs, standard demand curves.
The monopolistic company makes independent decision in each one of
the markets and the dumping has no consequences on the consumers of
the domestic market. The equilibrium will be given by the level of
output qDM and the price level p, which are the same than the ones
prevailing before the monopolistic company starts exporting.
However, in the foreign market the foreign producers lose the market
share gained by the monopolistic firm (q*).
The loss produced to the foreign producer may even cause that it does
not reach a level high enough as to be competitive in the international
market by taking advantages of the economies of scale existing in the
production of this goods.
20
Foreign market of dumper :
Prices
Local monopoly becomes
Cournot Duopoly
Home market of dumper
See Cournot graphs :
demand is shared, profits
fall !
p
p*
MC
D*r
q*
MR* (D*r)
q*E
MR
qqM
D
q
Where: * represents variables related to foreign market.
MC is the marginal cost, D the demand, q the quantity, p prices and
MR is the marginal revenue .
21
5.3.4. Anti-Dumping interventions
Dumping leads to political problems caused by the damage that it might
cause to the importing country. Importing country consumers are better, but
producers are confronted with unfair competition. Dumping demands are
managed at the level of the WTO, where the national damage must be
proved. At this level WTO can approve the use of antidumping duties.
Political conditions
1. Price
2. Damage to producer [can be shown in constant MC case
and Cournot duopoly : see sec. 5.4.]
3. Interest of the country (consumers vs. producers)
22
5.4 Cournot quantities and reaction functions under Duopoly?
1. Assumptions
5.4.1 Assumptions
2. Demand
• 2 firms: domestic firm and foreign firm.
3. Profit max.
• 1 market.
4. Reaction functions
• Each firms takes the others production as given.
= Cournot-Nash assumption
5. Monopoly contested
5.4.2 Demand
6. Pricing
7. Comparison
The global demand (Q) is the addition of the demand of the two firms
(q and q*, for local and foreign firms) , and it is a linear function of
prices:
aQ
Q  q  q *  a  bp  p 
b
23
5.4.3 Firms profit maximization
Each firms maximizes its profits (П). Taken the others’ production as
given, they adjust their production through reaction curves.
The maximization problem of the domestic firm is:
Max q  : pq  q *q  C q   F

pq  q *
C
q
 pq  q * 
0
q
q
q
And, the maximization problem of the foreign firm is:
Max * q * : p * q  q *q * C q *  F *
 *
p * q  q *
C
 q*
 p * q  q * 
0
q *
q *
q *
MR(q*,q)
MC(q*)
The equilibrium quantity implies that marginal cost equals marginal revenue.
24
5.4.4. Reaction functions of firms (quantities)
Assuming constant marginal cost and linear demand in the FOC (MR=MC) :
C
 c'  const. MC.
q
p
1
Q  a  bp ,
  (linear demand)
q
b
The reaction function, q(q*), of the local firm comes from the first order
condition of the profit maximization problem (solving it for q):
 1  a  q  q *
FOC : q   
 c'
b
 b
2q
a q*

 
 c'
b
b b
q
a  q * c ' b
2
The reaction function reflects the behavior of the firm regarding each
possible quantity of the other firm.
25
Properties of the Reaction Function :
The reaction function is downward sloping and shifts to
the right when the marginal cost of the firm falls


The equation of the RF shows the negative effect of q* and of
c’ on q.
a  q * c ' b
q
Explanations :
2
 When the competitor expands, this lowers the market price
(along the demand curve) and/or lowers the « residual
demand » for the firm: this firm lowers its quantity to limit
the fall in price which would hurt its « margin » (p-c’: see
5.2.2. « oligopoly pricing » above), but this also gives
« room » to the competitor until quantities converge to
equilibrium (see next slide, and also « strategic » slides
below).
 A fall in marginal cost increases the « margin » and
stimulates production.
 The firms with the « lowest margin » is also the most hurt :
26
it « retreats ».
The reaction function of the foreign firm is:
q* 
a  q  c' b
2
Which are the equilibrium quantities of the Duopoly?
The Cournot duopoly equilibrium is given by the intersection of
both reaction curves:
q*
Domestic firm’s reaction function :
q(q*)
q *E
Foreign firm’s reaction function: q*(q)
qE
q
27
3. Home reaction to
foreign entry
5.4.5. Duopoly as contestation of monopoly
Taking foreign
quantities as given
= acting on
residual demand
Graphical presentation starting from a firm’s monopoly quantity x M
p
1. Home monopoly
p
M
MC
MR
O
Domestic firm
reaction function
Demand
qr
2. Foreign firm contests
home firm’s monopoly:
q*(qM) > 0
q  q(q*)
Foreign firm q*  q * (q)
reaction
function
E
q*(qM)
O
MC
q
q*
q E*
pr
qE
D
Dr = residual demand
= D-q*(qM)
qM
q*E
Reaction function:
home firm finds
best response to
any possible x*
q*(qM)
0
4. Chain reactions
until E is reached
x
E
qr+q*(qM)
MR(Dr)
qE q r q
M
28
5.4.6. Duopoly pricing
First order condition MR=MC :

m
pq  q *1  Q   c' q 
  p 
Solved for p :
P = C’ [ / ( - m) ]
or
m
p  MC
 pi
q
p
As it is the case in Cournot oligopolies, the domestic firm acting in
duopolistic competition can manage its quantity and hence price, which will
depend on its market share m and the price elasticity demand .
The higher the demand elasticity to price and the lower the market share, the
lower the price that the firm can charge to consumers.
But opposite to what happens in the monopoly case, in the duopoly, a firm
loss is more than compensated by a gain in consumers welfare. As we can
see in the demand function a decrease in prices is a loss for producers fully
internalized by consumers gains; while an increase in quantities leads to a
net gain for consumers.
29
5.4.7. Equilibrium prices, quantities and profits : Duopoly vs. Monopoly
Duopoly : lower prices, higher total sales, lower joint profit
•Price : P = C’ [ / ( - m) ] < PM = C’ [ / ( - 1) ]
given that market share m = 1 in monopoly case
and 0 < m < 1 in oligopoly case
(and  > 1 in imperfect competition)
•Quantities: q < qM : lower prices under same downward-sloping demand
curve and observation : 2 xE > xM : graph of reaction function.
•Incentive to form a cartel : manage quantity jointly (reduce to monopoly
quantity), share higher profit. Also incentive to cheat in a cartel : exceed
quota and enjoy high price if other firm sticks to quota.
30
5.5 How can two monopolistic companies practice reciprocal dumping?
Trade flows that emerge from price discrimination
can take place in two- ways flows in the same
product: two monopolistic companies on their
respective local markets can use a dumping strategy
to take part of the other’s market. The opportunity to
sell at lower price in the other market is that
elasticity is higher than in the domestic one.
5.5.1 Assumptions
• 2 monopolistic companies: domestic and foreign (*).
1. Assumptions
2. Output
3. Welfare and
transportation
4. Strategic
investment
5. Strategic
subsidy
• 2 markets.
•There are unitary transport costs for both firms when they sell in their
foreign market.
• Both firms objective is to maximize their own profits.
31
The notation that is going to be used is the following:
• X is the home market, though x is the domestic firm production for
the home market and x* is the foreign firm production for the home
market.
• Y is the foreign market, though y is the domestic firm production for
the foreign market and y* is the foreign firm production for the
foreign market.
• t and t* represent the transport costs of each firms..
• П is the profit function.
• F is the initial investment.
32
5.5.2 How do firms chose their production levels?
By maximizing the profits.
Domestic firm’s problem:
Max( x, y)  xp( x  x* )  yp* ( y  y* )  c( x  y)  ty
Foreign firm’s maximization problem:
Max( x*, y*) *  x* p( x  x* )  y* p* ( y  y* )  c* ( x*  y* )  t * x*
To determine their production levels firms calculate the first order
conditions for which they take the other firms production as given.
33
Domestic firm maximization problem:
First order
condition 1:
  
   p( x  x*)  xp' ( x  x*)  c' ( x  y)  0
 x  x*
MRDx , x, x *  MC x, y, F 
Where:
MC
0
F
First order
condition 2:
 

 y

  0
 y*
MRDY , y, y *  MC x, y, F   t
34
Foreign firm maximization problem:
First order
condition 1:
  * 

  p( x  x*)  x * p' ( x  x*)  c*' ( x *  y*)  t*  0
 x *  x
MR * Dx , x, x *  MC * x*, y*, F *  t *
First order
condition 2:
  * 

  0
 y *  y
MR * DY , y, y *  MC * x*, y*, F *
35
As in the case of the duopoly, firms are going to chose their production
level by taking the other firms production as given.
• Reaction function for domestic market of domestic firm:
x  f x*, MC x, y, F 
• Reaction function for domestic market of foreign firm
x*  g x, MC * x*, y*, F *
If x*=0, local firm behaves as a monopolist.
If x=0, the foreign firm is the one that has monopoly power.
36
If one of the firms has monopoly power in one market, the other
firm will only enter if it can add production. The production
equilibrium point will be in the reaction function space, where the
curves cross.
In equilibrium, the quantity supplied to the economy has increased
and prices have decreased
[ see reaction space above, under 5.3.3. and discussion 5.3.7.]
Next :
-Discussion of the welfare effect of reciprocal dumping
-Discussion of firms and governments strategic behavior (reactions)
37
5.5.3. Partial equilibrium welfare effect :
Reciprocal dumping and transport costs
Assume identical firms and identical
countries for this graph.
Price
PM
PX
R
S
MC+t
T
MC
Compare domestic monopoly with
symmetric reciprocal dumping.
A
F
B
C
G
E
H
M
MC * t *
D
MC
TD
MR
xH
xM
xH  x *
Quantity
38
The autarkic situation corresponds to the existence of monopoly,
then the initial equilibrium is given by (xM, pM), in the local market.
Monopoly profit in autarky:
PM  MC * xM
Under free trade the price level is lower (px) and welfare
distributions take place between foreign and domestic agents.
Consumers have double gain from price reduction and quantities
increased. The increase in quantity leads to net gains (triangle ABC)
for the economy.
Producers net effect is undetermined, as they have a loss given by
transfers made to consumers and foreign producers and they gain
from taking position on the foreign market.
The welfare effects will be analogue for both markets.
39
The welfare effects of trade for domestic agents are:
Consumers gain:
Transfer made by
monopolist to consumer
Producers
profits in
duopoly:
Net gain
Net gain
Domestic
profits
Foreign
profits
Net loss. Net use of resources in transport
costs.
Total effect for the economy will depend on the relation between the
net gains of consumers and producer, and the net loss arising from
the transport costs.
40
Welfare Effect of transport cost
Welfare
Duopoly
Monopoly
Transport costs might determine
the existence of trade.
If they are too high the
monopolistic condition may
remain.
0
t=p-MC Transport
cost
Zero transport costs are better than no-trade, but as transport cost increase they
eat up profits and reduce quantities available to consumers. Welfare falls.
Starting from high transport costs, a fall gives rise to a lot of costly transport
activity and not much consumption gain or profit. The waste dominates the
gains. However, firms are forced to trade because of competition risk in their
domestic markets.
As we can see small reductions in high transport costs reduce welfare;
intermediate transport costs are not necessarily good, they are a “trap”.
41
Evaluation of the perception of a higher demand elasticity on
foreign market than in domestic market :
• Sale opportunity ?
• Profit trap ?
• Consumers risk ?
Higher foreign demand elasticity gives an
opportunity to sell a marginal quantity in the
foreign market without lowering price as much as
in domestic market for the whole output, even if
this is done by selling abroad at a lower price than
domestic price (indeed foreign marginal revenue
may be higher than home).
Total effect on profits will depend on the weight of
gains and losses. From one side the producer has
gains from selling abroad, and from the other side
he has to confront transport costs and take the risk
that competitors enter into his own market.
Consumers always gain from the increase in
competition. They benefit from higher
quantities and lower prices. But home
consumers of a firm dumping abroad may face
higher prices at home.
42
5.5.4. How is the local firm going to react? Strategic investment !
Local firm will tend to reduce it’s marginal cost permanently, so the
increase in production leads to a price reduction, increasing the
production of the monopoly and decreasing the attractiveness of the
market to the other firm.
The marginal revenue needs to be enough to cover the marginal costs,
and as fixed costs need to be covered as well, this mechanisms leads to
overproduction, only by the purpose of maintaining the monopoly.
The way the firm has to reduce it’s marginal cost is increasing the
investment (F). By increasing initial investment, the marginal cost
decrease and the reaction function of the domestic firm moves to the
right.
The local firm increases it’s production and reduces it’s competitors.
The price reduction is not maximal as the reduction of the competitors
supply is additional gain to the marginal cost reduction.
43
Overproduction or overcapacity
Capacity investments to reduce MC
px
Demand
Overcapacity increased :
AC>MinAC
p xM
p' xM
MC
MC '
MR
x
x*
x'(x*)
x*(x)
E
F’
F
P
P’
AC’
AC
MC
MC’
x
Also product differentiation
x(x*)
xM
xM '
x
44
Both firms have the incentive to invest at the margin.
Problem:
There is a prisoners dilemma.
Domestic firm
Foreign firm
Fix F
Increase F
Fix F
Increase F
(0,0)
(-10,10)
(10,-10)
(-5,-5)
The Nash equilibrium will be non cooperative (-5,-5),
but the optimal (for the firms) was (0,0).
Big winner is the consumer.
45
5.5.5. How can the government react? Strategic Subsidy !
By giving a strategic subsidy to the domestic firm. This has the same
effect than reducing the marginal cost. The problem arises from the fact
that if both governments give subsidies to their firms we are again on a
prisoners dilemma.
The effect of the strategic subsidy is:
d
 x
 x * x




?0
dS
x S
x * x S
S
1
2
3
We assume that the firm sells on a third market, so we do not have to
take domestic consumer surplus effects into account.
46
1
Direct effect of subsidy on output: at the margin the firm is
in equilibrium. Then the effect of the subsidy around the
optimal is zero (Envelope theorem).
 x
0
x S
2
 


0
 x

Indirect effect: reaction of the firm’s output to the production
of the competitor is positive.
x *
x
 x * x
 


0
;

0
;
 0
 0  x *
x
S


x * x S
3
Direct effect on profit is positive.

0
S
47
Total effect of subsidy is positive. Subsidy will increase profit beyond
the transfer because of the reduction in competitors production.
d 

 0 Total effect is higher than the marginal effect.
dS S
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Other effects in oligopolies (other cases than reciprocal dumping)
-Effect on profits
loss of profits due to increased competition from home firms
in the domestic market of the dumper
…
Effect on consumers
domestic consumers may lose from higher domestic prices if
there is no domestic competition and marginal cost of
dumper is increasing, while foreign consumers gain.
Prices may rise in integrated market (non-segmented), if
monopolist enjoys higher demand and constant or
increasing marginal cost
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5.6. Exchange-rate pass-trough
The fact that imperfect competitive firms can manage both, prices and
quantities, implies that they do not necessarily totally adjust their prices
to changes in the exchange rate.
Pass-through :
E  p
Definition:
Perfect competition
Imperfect competition
E  p
E  Q
P / P

E / E
Exchange rate depreciation makes the price of exports in foreign currency
cheaper. Domestic companies could reduce their prices on export markets,
however they will not fully pass this trough to foreign consumers because
their foreign competitors do not have the advantage of exchange rate
depreciation. Domestic exporters will partly lower prices and partly raise
their margins abroad given that they gain some market share abroad anyway.
On the home market domestic firms could increase their prices because
imported goods are more expensive, but they will prefer some output gain to
a full pass-through into domestic prices.
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Purpose of the model: show the elasticity of the domestic market price p to
the exchange rate e (price of foreign currencies) and show the reaction of
the quantities sold by the firms on the domestic market.
Assumptions: an “average firm” on the oligopolistic market (for simplicity
of algebra).
Firm’s Sales : qQ / N Where N=n+n*
Firm’s Cost : wq
Market Demand curve :
Q a bp
or p  (a  Q) / b
Firm’s profit:   q  [( a  Nq) / b]  wq
First order condition:

q
 0
p
q   p  w  0  MC  MR
Q
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1 

1 
p  w
N



MR = MC
Solve for p :
Since:
 N 
p  w


N

1


 b
p
Q
where
 
Q p
p Q
p (Nbp  Q)  (wn  n*ew*) bp
Q  a  bp
wN  wn  w*en *
a
wn  w * en *
p

N  1
bN  1
Hence (from p) the elasticity or pass-through :
p e
n * w* e
 


1
e p
N 1 p
Since n* < N and w*e < p;
if price is above marginal cost.
52
Discussion : case of the home market after home currency devaluation :
-Foreign Firms:
-- effect of their relative number (or market share):
Then the smaller the number of foreign firms n* relative to market N, the
smaller their ability to pass cost to the domestic country prices, and the
stronger the fall in their sales. Nevertheless, they prefer to continue some
sales (keep a market share) rather than withdraw totally.
--case of a foreign monopoly:
Note that even a foreign monopoly (n*=N) will not fully pass the exchange
rate shock to prices because it also cares about sales and always keeps
p>ew*, hence ε<1.
--case of foreign perfect competition but 100% market share :
If there is foreign perfect competition and no domestic firm (home is pricetaker) p=ew*, n*=N, hence ε = 1.
-Domestic firms:
Benefit from some price increase, and some market share gain on home
market.
53
Empirical evidence : The Economist 6 Dec. 2003, p. 67
The Economist claims :
1. about the difference between the 80’s and
90’s: “First, in an increasingly integrated
global economy, companies' pricing power
has been eroded around the world. In
addition, low inflation has made price
increases more obvious. So it is harder for
firms to pass on cost increases of any sort…”
(increasing competition)
2. about limited “pass-through”
“Other factors also weaken the power of
currency movements. Rather than try and
raise prices when their “home” currency
strengthens, foreign firms may hold prices
and accept lower margins, especially if they
think the currency will weaken again(*) or if
they are determined to maintain market share
(**).” (pricing to market).
(*) On the “option value of waiting to leave” Krugman (1989) “Exchange rate instability” MIT Press, Chap. 2.
(**)This part of the course, See also: DORNBUSCH, R. (1987) “Exchange rates and prices” American Economic Review 77,1, March.
54
The other face of the same problem :
Quantities and market shares !
On the cost side we know that
wages and exchange rate move
together. Higher exchange rate
(domestic depreciation) increases
foreign cost relative to local
costs. Then, the marginal costs of
the foreign firm will be higher,
moving its reaction function
leftwards. The market share of
the foreign firm decreases and the
one of the domestic firm
increases. The depreciation acts
as a ‘strategic’ subsidy for the
domestic firm. Total sales
decrease after a devaluation,
prices increase but not 1 to 1.
x*
x  (x*)
x* E
E
E’
x * E'
xE
xE'
x*  ( x )
x
55