Question 2

20marks (4+4+4+4+4)

In a country called Loonyland, production technology in the cookie industry (denoted ) is such that firms have constant marginal cost , but they must also incur a fixed cost of production, . There are many firms in industry , they are all identical, but they compete by producing a different variety of cookies. There is free entry and exit in the cookie industry, which drives profits to zero in equilibrium.

a.(4 marks) If any individual firm produces output (cookies) , find the firm's average cost curve. Assuming that each firm has the same market share so that (where the size of the market is and is the number of firms in the industry), show that the equation for the curve is given by:

Curve:

b.(4 marks) Does the production technology in the cookie industry display decreasing, constant, or increasing returns to scale? Explain your answer.

c.(4 marks) Suppose that the curve, which summarises price competition in the cookie industry, is given by the following equation:

Curve:

Graph the curve and the curve (with the number of firms on the horizontal axis) and solve for the autarky equilibrium in the cookie industry; that is, find the equilibrium number of producers and the equilibrium price of a cookie.

d.(4 marks) Suppose that Home is now able to trade with another identical country. Solve for the trading equilibrium in the industry and illustrate this trading equilibrium on your graph in part (c).

e.(4 marks) Give two reasons why trade in the cookie industry would lead to gains from trade.