Regional and European Economic Integration - Spring 2010
Imperfect Competition and European
Economic Integration
Lorenzo Rotunno
21/04/2010
Imperfect Competition and European Economic Integration
2
1 European liberalization and Market Size Effects
1.1 Equilibrium in Autarky
Figure 1
Price
Price
Home Market
Mark-up (μ)
BE curve
E’
E’
E’
μ'
p’
COMP curve
AC (Average Cost)
n’
Demand
x’
Sales per firm
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C’
Tot. sales
N. of firms
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1.2 Equilibrium in Autarky (cont.)
Recall the logic behind the BE-COMP diagram: the COMP curve tells that the mark-up in the market
0
0
0
is when there are n rms. The BE curve tells that n rms break even (i.e., survive) when the
0
mark-up is .
The intersection of the BE and the COMP curves gives the mark-up and the number of rms in the
long-run equilibrium.
In the short-run, some rms can make pure pro ts or losses, but free entry leads to the BE curve in
the long-run. Rather, rms are always on the COMP curve, since they adjust the mark-up quickly in
response to a change in the number of rms.
0
0
From the mark-up we obtain the equilibrium price p ; and the quantity sold in the market C .
0
0
The long-run equilibrium sales of the typical rm equal x , where the p = AC .
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1.3 Market liberalization: the Verbal Logic
The removal of trade barriers:
enlarges the market =) de-fragmentation;
exposes rms to a higher degree of competition =) pro-competitive effects;
the least ef cient rms are driven out of the market or merge to attain economies of scale =)
industrial restructuring;
The nal result of this process is a more ef cient industrial structure, lower prices and larger output.
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1.4 No-Trade-to-Free-Trade liberalization
Two identical countries remove trade barriers completely between them =) effects are identical. Focus
on one country, Home.
Figure 2
Price
Price
Home Market
Mark-up (μ)
BE
BE FT
E’
E’
p’
A2
E’
AC A> p A
E’’
A1
p’
’
p’’
pA
pA
1
μ'
p’
E’
’
E’’
μ'’
A
μA
A
COMP
AC
MC
n’
Demand
x’
x’’
Sales per firm
2CA/2n’
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Tot. sales
C’C’
’
CA
n’’
2n’
N. of
firms
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1.5 No-Trade-to-Free-Trade liberalization (cont.)
Short term effects:
Market size effects: each rm faces a doubled market =) more rms can break even for any given
mark-up.
0
To get the position of the new BE curve: suppose does not change (though this is not the case)
0
=) the number of rms will double (point 1), since each rm will sell the same amount of good, x ,
but now the market size has doubled. The new BE curve has to pass through point 1.
The mark-up adjusts immediately to the higher number of rms, from
effect).
How many rms would break even at A? In the short run, 2n
and 50% export sales). But they would be losing money, since
0
0
to
A
(pro-competitive
rms (each rm has 50% domestic
A is too low to cover xed costs.
Long term effects:
The number of rms will decrease (industrial restructuring) until rms in the market will break even.
In the long-run equilibrium, there will be fewer rms than in the short term (but more than in autarky),
00
selling at a higher mark-up .
Firms are larger (as a result of the market de-fragmentation) than in autarky and more ef cient
(lower average costs). Prices go down and demand increases.
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1.6 No-Trade-to-Free-Trade liberalization (cont.)
Welfare Effects:
00
00
From autarky, prices go down to p and thus demand expands to C .
Usual welfare gains: consumers pay less the previous purchased quantity (area A1, terms of trade
effect) and increases their demand (area A2, trade volume effect).
Producers surplus does not change: there are zero pro ts in autarky and after the liberalization in
the long run equilibrium.
There are no changes in tariff revenues, since these were absent before (think of the trade barriers
as transport costs).
The welfare analysis does not take into account the adjustment costs from the short term to the
long term equilibrium. In economic terms these are not losses: resources are used more ef ciently;
but can be politically important (justi cation for controls on state aid and competition policies).
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2 State Aid
The adjustment along the COMP curve from the short run to the long run equilibrium entails industrial
restructuring, i.e. mergers, acquisition and bankruptcies.
The government might want to avoid this because of social considerations (job losses or job conversion) or because of pressure from organized lobbying. Subsidies are often used to this purpose.
2.1 Industrial Subsidies and Market Integration
Both governments pay subsidies such that rms do not incur losses following market integration.
This prevents industrial restructuring (no rm exit).
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2.2 Industrial Subsidies and Market Integration (cont.)
Figure 3
Price
Price
Home Market
Mark-up (μ)
BE
BEFT
E’
E’
p’
E’
AC A> p A
D
A
pA
1
μ'
p’
pA
μA
A
B
A
COMP
C
AC
MC
n’
Demand
x’
Sales per firm
2CA/2n’
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C’
CA
Tot. sales
2n’
N. of
firms
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2.3 Industrial Subsidies and Market Integration (cont.)
0
After the liberalization the number of surviving rms equal 2n .
The mark-up decreases to
A
, and the output/demand increases to CA .
0
Firms can now sell in a larger market 2CA. Therefore, the typical rm's sales increases from x to
CA
xA = 0 .
n
Welfare effects:
Public expenditures equal the gross pro t loss from liberalization. In autarky industry's pro ts were
0
0
C = A + B. After the liberalization with subsidies, pro ts are ACA = B + C. Thus, pro t loss =
subsidy = A - C.
Consumers gain the areas A (trade price effect) and D (trade volume effect).
Producers' welfare do not change: they earn zero pro ts before and after liberalization (even though
now there are more surviving rms).
Net welfare effect = A + D - (A - C) = D + C.
Liberalization with subsidies is welfare improving since it expands production and demand in a
framework with imperfect competition (the marginal utility of an additional unit is higher than its
marginal cost). It is nevertheless a second-best solution.
The analysis does not consider likely long-run costs in terms of weak innovation potential.
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3 Anti-competitive Behaviour
Market integration leads to higher competition and a lower the number of rms. These rms might be
tempted to coordinate their actions to arti cially increase prices, i.e. they might collude.
The COMP curve relies on normal competition: each rm takes the other rms' sales as given. At
the other extreme, under perfect collusion all rms act as a single monopolist, charging the highest
possible price.
For the sake of simplicity, we assume that the monopoly level of sales is redistributed equally among
rms, even though there is a strong incentive for each single rm to sell more.
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3.1 Collusion and Market Integration
Figure 4
Price
Price
Em
Home Market
Mark-up (μ)
BEFT
Em
pm
Em
μm
Pm
2
Perfec t
collusion
AC m < Pm
E’’
p’
’
p’’
E’
’
μ'’
E’’
COMP
AC
MC
n=1
Demand
xm
x’’
Sales per firm
Regional and European Economic Integration - Spring 2010
Cm
C’’
Tot. sales
n’’
2n’
N. of
firms
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3.2 Collusion and Market Integration (cont.)
At the monopolist mark-up, m , the mass of surviving rms would be given by point 2. However,
this would entail free entry (unlikely after liberalization). Suppose that the number of rms stays at
0
2n , corresponding to Em .
All rms would be making pro ts (as long as there is no entry) since at Em , pm > AC .
0
At the price pm and with a number of rms 2n , sales per rm is xm and total output/demand is Cm .
Under perfect collusion, prices are higher and total output is lower than under the free trade long-run
equilibrium.
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3.3 Partial Collusion
Perfect collusion is hardly sustainable because of the incentives to deviate. Partial collusion can be a
solution: the mark-up is higher than that under normal competition (i.e., the COMP curve), but lower
than the monopoly mark-up.
The partial collusion curve will be between the perfect collusion and the COMP curve.
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3.4 Partial Collusion (cont.)
Figure 5
Price
Price
Em
Home Market
Mark-up (μ)
Em
pm
Pm
μm
p PC
p PC
μPC
E’’
p’
’
p’’
Em
2
Perfec t
collusion
EPC
A’’
Partial
collusion
E’
’
μ'’
E’’
BEFT
COMP
AC
MC
n=1
n’’
Demand
n PC
xm
x’’
Sales per firm
xPC
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Cm
C’’
CPC
Tot. sales
2n’
N. of
firms
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3.5 Partial Collusion (cont.)
0
00
If all 2n rms partially collude, the mark-up is at point A . This mark-up is not enough to cover xed
costs =) industrial restructuring will trigger until the the long-run equilibrium with collusion, EP C ,
is reached.
The mark-up, and thus the price, are higher than without collusion. Consequently, total output/demand,
00
CP C , is lower and rms are smaller (xP C < x ). The partial collusion outcome can be seen as
something between normal competition and perfect collusion.
Note that under partial collusion rms gain zero pro ts in the long run and make losses in the short
run. The above-normal mark-up allows less ef cient rms to survive.
The welfare change vis-à-vis free trade without collusion is negative and concern consumers surplus.
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4 Summary
Imperfect competition explains important aspects of European integration.
Market integration is bene cial since it delivers a more ef cient industry, higher output and lower
prices.
All policies that prevents industrial restructuring (anti-competitive behaviour and state aid) hinders
the positive effects of market integration.
Collusive behaviour has negative static effects while state aid is likely to have negative dynamic
effects (i.e. rms have weak incentives to innovate).
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