Cost, efficiency, and the optimal number of firms in spatial markets

Abstract

In markets where firms and buyers are separated by costly distance, the degree of competition is believed by some economists to be less than perfect. Under these circumstances, many economists have demonstrated through the use of theoretical models that the long run equilibrium outcome does not contain all of the desirable features that exist in perfectly competitive industries. Specifically, it is suggested that there are too many firms and each firm's rate of output is too low to achieve the minimum average cost of producing and transporting its product. Since resources are believed to be employed in less than the optimal manner, some theorists suggest that some form of government regulation can improve the performance of spatial markets and can achieve the "optimal" number of firms. A widely accepted theoretical model representing a spatial industry has evolved in the literature. Basically the same model is presented in this dissertation except that the abbreviated cost function used in spatial models is replaced with one that contains the more generally accepted U-shaped average cost characteristic. The model is then used to examine a variety of industry solutions under the condition that each firm is forced to charge a price that is equal to its average cost of production. Maintaining the zero profits condition, a planner may alter the number of firms in order to achieve a variety of results, each of which contains some desirable feature. The model is also used to examine three of the possible free market equilibria. Each of the market solutions is unique because of the different price reactions that are assumed to exist between the firms. After obtaining the market results and the planner's results the two are compared to determine the possible conditions that can exist in a spatial industry. After the comparison, some concluding remarks are offered.