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Question from Past Microeconomics Qualifying ExamEdit

Spring 2006 - Section II, Question three, George Mason University

A firm’s production in the steel industry has the following TC function: TC(q) = K + q2, where K ≥ 0 is a fixed cost. Assume that industry demand intersects the AC curve in the downward-sloping region, i.e., at an output level below the minimum efficient scale. Describe the equilibrium given perfect contestability with as much precision as possible. Assess and diagram its Kaldor-Hicks efficiency.

AnswerEdit

Here's my attempt, but my confidence is low on this question and I am not good with graphs. Please critique.

There are falling returns to scale and fixed costs at each firm. Assuming that the industry starts out with one firm and that competition would reduce economic profits to a maximum of zero (this could be modeled as in Bertrand competition), a second firm would find it unprofitable to enter, as each firm's supply curve following entry would have a discontinuity in the region of falling AC through which the demand curve passes, violating the no-shutdown condition.

Thus this industry is a natural monopoly. The monopolist sets MR=MC and produces according to the graph below. Assuming the monopolist is unable to price discriminate, we have the green region of consumer surplus, the yellow region of producer surplus, and the red region of deadweight loss vis-a-vis a hypothetical regime of perfect price discrimination.

MicroS06ii.3


Price being equal to the ATC, but not at the minimum, with profits at zero but still less KH efficiency then would be the case with perfect competition--is the standard result for long term equilibrium in a monopolistically competitive market. Here's a good link:

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