Internal economies of scale imply that as output increases, the average cost of production falls i.e. average cost curve slopes downwards.
Whenever average cost is decreasing, the marginal cost will be less than the average cost because average cost includes the cost of those initial units that were produced at higher unit costs.
So, the marginal cost curve lies below the average cost curve. In this situation, if a firm sets its price equal to marginal cost (the cost of producing one extra unit of output), the average cost will be greater than the price; thus the concerned firm incur losses. The firms cannot sustain these losses and has to shut down in the long run.
Represent the graphs showing the price determination under perfect competition and internal economies as follows:
In figure (a)firm under perfect competition sets the price equal to marginal cost where it is also equal to average cost, marginal revenue and average revenue. While, in the figure (b), firm under internal economies sets the price equal to marginal cost, so, the average cost being greater than the marginal cost, will incur losses.
Thus, firms can't set price equal to marginal cost when there are internal economies of scale because they incur losses.
If the two countries integrate their automobile industry with a third country, the number of firms, output per firm and the price per automobile is calculated as shown below;
The relation between average cost fixed cost and marginal cost is given by the below expression.
Average Cost is represented as AC ,
Fixed Cost is represented as F ,
Marginal Cost is represented as C ,
Output of the firm is represented as Q,
Price is represented as P ,
Number of firms is represented as n ,
Constant (responsiveness of a firm's sales to its price)is represented as b ,
Calculate number of firms:
Since average cost per unit is same as the price, equate the average cost with price;
However, S gives total output of the industry and it is equal to
as shown below;
Total output S is equal to the total market of the three countries;
Therefore, total market output of the three countries is 6.25 million.
Substitute S , b , and F value into equation
However, fraction of 15.8 firms does not exist, there will be 15 firms in the automobile industry (not 16)as the 16 th firm cannot cover its average cost or its average cost is higher than the market price of the industry.
Calculate Output per firm:
Therefore, output per firm is 41,666 units.
Calculate price per automobile:
Therefore, price per automobile is $7,000.
Therefore, the total number of firms is 15, output per firm is 41,666 units, and the equilibrium price charged is $7,000.
(a)It is given that P = 17,000 + (
), where P is price and n is the numbers of firms.Now, as we know that
Where, AC = average cost F = fixed cost Q = output of firm C = variable cost (marginal cost depends on variable cost and is independent of fixed cost)S = each country's market for the automobile sector
Since average cost per unit is same as the price; AC = P ,
17,000 + (
..... (1)Now, the value of S in United States is 300 million. So, Substituting the values for S , F , and C in equation (1)we get the value of n for United States; n = 3. Similarly the value for S in Europe is 533 million. Substituting the required values in equation (1), we get the value of n for Europe; n = 4.
(b)Substituting the value for n in the equation P = 17,000 + (
)we get the value of P for United States; P US = 17,000+
Similarly, substituting the value for n in the equation P = 17,000 + (
)we get the value of P for Europe; P E = 17,000 +
(c)The combined value of S in United States and Europe is 833 million (300 million+533 million). Substituting the values for S , F , and C in equation (1)we get the value of n for both United States and Europe; n = 5.
Now, substituting the value for n in the equation P = 17,000 + (
)we get the value of P for United States and Europe; P = 17,000 +
(d)In both countries, the price of automobiles has fallen to $17,030 per automobile due to free trade. So consumers have to pay less for a purchase of an automobile after trade is opened. Not only this, consumers in each country have more variety of brands available after trade. In United States, the number of brands increases from three to five while that in Europe increases from four to five. Thus consumers in both countries are better off with trade.