Economics
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Figure 3.8. Prices, Output, and Equilibrium Firm Size with Integration Home market only euros
markup
price
demand curve
BE BE FT
E’
p’
E’
E’ E”
p”
p”
1
µ'
p’
E”
E” A
pA
A
µA
AC
COMP
MC n’ x’
x”
sales per firm
C’ C”
n”
2n’ number of firms
total sales
Source: Author’s elaboration.
It is useful to think of the integration as taking place in two steps, as follows. 1. Short term: Defragmentation and the procompetitive effect (from E' to A). We start with the short-term impact, that is to say, the impact before the number of firms can adjust. Before the liberalization, each market was extremely fragmented in the sense that firms in each country had a local market share of 1/n' and a zero share in the other market. After the liberalization, the market share of each firm is the same in each market, that is, 1/2n'. This elimination of market fragmentation has a procompetitive effect, which is defined as a decrease in the price-cost markup, shown in the righthand panel of figure 3.8 as a move from E' to A. The short-term impact on prices and sales can be seen in the middle panel as a drop from p' to pA. 2. Long term: Industrial restructuring and scale effects (A to E"). Point A is not a long-term equilibrium because the operating profit earned by a typical firm is insufficient to cover the fixed cost. We see this by noting that point A is below the BE curve, telling us that the markup is too low to allow 2n' firms to break even. To restore a normal level of profitability, the overall number of firms has to fall from 2n' to n". In some cases, this process occurs via mergers and buyouts; in others, the number of firms is reduced by bankruptcies. As this industrial consolidation occurs, the economy moves from point A to point
E ". During this process, firms enlarge their market shares, the markup rises somewhat, and profitability is restored. The welfare effects of this liberalization are straightforward. The four-sided area C marked out by p', p", E', and E" in the middle panel of figure 3.9 corresponds to the gain in the Home consumer surplus. As usual, this gain can be broken down into the gain to consumers of paying a lower price for the units they bought prior to the liberalization and the gains from buying more (C " versus C '). Exactly the same gain occurs in the Foreign market (not shown in the figure). As it turns out, the four-sided region labeled C in figure 3.9 is Home’s long-term welfare gain because there is no offsetting loss to producers and there was no tariff revenue to begin with. Firms made zero profits before liberalization, and they earn zero profits after liberalization. Note, however, that this long-term calculation ignores the medium-term adjustment costs. The discussion above has shown that integration initially leads to big price reductions and large profit losses. These profit losses are eliminated as the number of firms falls and as profits are restored to normal levels. During this industrial restructuring process, prices rise slightly. This sequence of steps, sometimes called industrial consolidation or an industry shakeout, is relevant to some industries. In other industries, firms anticipate the increased competition