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price leadership model versus a contestable markets model

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Suppose you have an industry with 20 firms and the CR is 30%. How would you describe this industry? Suppose the demand for the product rises and pushes up the price for the good. What long run adjustments would you expect following the change in demand? What does your adjustment process imply about the CR for the industry?

Now consider that the industry has 20 firms but the CR for the industry is 80% instead of 30% How would you describe this industry? What are some reasons why this industry has a high CR while the other industry had a low CR? Is it possible for smaller firms to thrive and profit in such an industry? How? Contrast the effects on market efficiency if the dominating firms use a price leadership model versus a contestable markets model

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Solution Preview

Concentration ratios are calculated based on the market shares of the largest firms in the industry.
An industry with 20 firms and the CR = 30% is called "Low Concentration", for a concentration ratio of 0 to 50 percent is commonly interpreted as low concentration. The industry is monopolistically competitive and that the four largest firms have very moderate market control.

When the demand for the product rises and pushes up the price for the good. Then in the short run, the existing 20 firms will make positive profit and become better off. The short-run equilibrium will be reached where marginal cost equals marginal revenue, i.e. profit maximizing.
However, In the long-run firms are able to change the scale of product and enter or leave the industry. New firms will also enter the industry to take advantage of the profit, and the total supply will be increased, which will press the market price down to the long-run equilibrium price (= the minimum LR average cost).
On the other hand, since this industry is monopolistically competitive, each firm has some power of price setting. They will compete for market share by charging a price lower than any other producers. This is called Bertrant Game, which will end in a lot of firms charging the long-run equilibrium price. At this point there is no incentive to entry and equilibrium is established

This adjustment process implies the relationship between CR and the properties of the industry. When CR is low, monopolistic competition occurs and the market exhibits elements of ...

Solution Summary

Contrast the effects on market efficiency if the dominating firms use a price leadership model versus a contestable markets model.

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