Theoretical Economics, Volume 5, Number 2 (May 2010)

Theoretical Economics 5 (2010), 215–239

Efficiency and marginal cost pricing in dynamic competitive markets with friction

In-Koo Cho, Sean P. Meyn


This paper examines a dynamic general equilibrium model with supply friction. With or without friction, the competitive equilibrium is efficient. Without friction, the market price is completely determined by the marginal production cost. If friction is present, no matter how small, then the market price fluctuates between zero and the "choke-up" price, without any tendency to converge to the marginal production cost, exhibiting considerable volatility. The distribution of the gains from trading in an efficient allocation may be skewed in favor of the supplier, although every player in the market is a price taker.

Keywords: Dynamic general equilibrium model with supply friction, choke-up price, marginal production cost, welfare theorems

JEL classification: D41, D51

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