9: Market Power and Monopoly
why does price have to fall for every unit the firm sells? 2 assumptions
(1) The firm's decision making isn't sequential - it doesn't decide to sell a second amount after selling some first amount. It decides on one amount and one price. This is because we assume demand to reflect demand within a given time period. (2) Price discrimination isn't possible
diagram of profit maximisation when a firm has market power? 3 steps
(1) derive the MR from the demand curve (2) find the output quantity MC = MR (3) find profit maximising price by locating the point on the demand curve at the optimal quantity level.
government intervention direct price regulation difficulties (3)
(1) only the company knows its true cost structure (demand curve and marginal cost) (2) the firm has an incentive to misrepresent the truth and make people believe costs are higher than they really are to justify a higher regulated price. (3) if the price cap is based on the firm's cost curve, then the firm has no incentive to reduce costs. --> The regulator would reduce the price cap, destroying any efficiency gains.
government intervention different uses of antitrust laws (3)
(1) to prevent firms from merging with or acquiring other firms to prevent them from becoming too dominant (2) to force a break up of an established firm that has too much market power (3) ban on collusion amongst competitors with regards to pricing and market allocation
monopoly and elasticity
- A monopoly will choose to operate only in regions where the market demand curve is elastic. - If it was on the inelastic part of the demand curve, it would immediately raise its prices, thus gaining revenue.
diagram showing how marginal revenue differs from price? Impact of increasing quantity on revenue. ALSO how does elasticity affect decisionmaking?
- Firms that have steep demand curves (elastic), obtain small revenue gains when they increase output. Therefore, high output levels are less profitable. EVAL: if MR goes negative, then they get losses. - Firms facing flatter demand curves obtain relatively large marginal revenues when raising output. Therefore, ceteris paribus, having a steeper demand curve tends to reduce a firm's profit-maximising output level.
how does a monopolist lose business?
- If it raises its price too much, it drives consumers out of the market. --> It doesn't lose business to direct competitors.
government intervention direct price regulation price cap diagram + explanation
- If the government imposes a price cap that forbids firms charging prices over Pc, then output is its perfectly competitive level, and consumer surplus is A+B+C
HOW does an industry with market power differ from perfect competition, in terms of setting eq price and quantity
- Takes into account MR (demand) and MC - NOT just MC so cannot be said to be a supply curve
government intervention direct price regulation why might governments set price cap above perfectly competitive level + IMPACT
- To allow firms to recoup high fixed costs. --> this creates DWL and less consumer surplus than in perfect competition
Impact of an increase in marginal cost when market power exists
- When MC rises, price rises and output falls HOWEVER this differs from perfect competition because P does not equal MC --> The firm doesn't want to pass on all of the price increase to customers to increase its profit --> Also, the drop in quantity is smaller. Nonetheless, Q is still smaller than in perfect competition.
What does the Lerner Index tell us?
- firm's should increase profit by marking up price with less elastic demand --> If we put in perfectly elastic and inelastic demand we can see how firms become price takers when ED = -∞, AND mark up is zero. perfect competition
types of barriers to entry
- high fixed/sunk costs - consumer switching costs - product differentiation - absolute cost advantage / control of key inputs - government regulation
example of why monopoly is good (drugs)
- if the MC is constant at $5 once a drug has been discovered. --> setting the price at $5 leaves no producer surplus - given the firm needs to spend huge amounts developing the drug, it will not do so if it must sell it at its marginal cost. - Thus the government promises the firm a monopoly on the drug it develops, allowing the to produce where MR=MC. - As long as the firm expects the fixed cost of discovering the drug to be less than B, it will produce. - consumers get surplus of A
Response to change in demand when market power exists
- increases both quantity and price
government intervention drawbacks of antitrust enforcement
- large costs/uncertainties - the government should not fight mergers and acquisitions that would increase efficiency and make consumers better off ( hard to differentiate between the two )
impact PED has on producer surplus
- producer surplus higher when demand curve is more inelastic --> Firms can charge a higher price.
consumer and producer surplus under market power vs. perfect competition
CS: the areas above the demand curve and below price PS: the area below rice and above the marginal cost curve - market power has greater PS - perfect comp has greater CS - DWL in market power perfect comp produces at MC market power MC = MR
Impact of market power on demand curve
Firms are not price takers because the price of its product depends on the quantity produced. --> If it produces more, it will drive down the market price. It faces a downward sloping demand curve where output and price are interrelated
government intervention how + why do governments promote monopoly?
How - Governments help them legally enforce their market power through patents, licenses, copyrights, trademarks Why - Creates market power, higher prices and lower quantities - Encourages innovation --> The consumer surplus creates by these new goods can outweigh the DWL i.e. medicinal drugs
absolute cost advantage example of barrier to entry
If a firm has control over a key input, it allows the firm to have lower costs than any competitor. This makes it difficult for other firms to take business away from the low-production cost firm. --> Creates market power.
mathematical support for natural monopoly HIGH FIXED COSTS
If fixed cost 100 and marginal cost of 10 per unit: TC = 100 + 10Q AC = 100/Q + 10 Therefore, average total costs decline across all quantities of output.
why are natural monopolies justified? under what market conditions?
In a market with high fixed costs and slowly rising marginal costs. Downward sloping long-run average cost curve. (1) If another firm enters, the industry's average total cost of producing rises because fixed costs are replicated. (2) The incumbent's size gives it a cost advantage meaning it will dominate the industry with its low cost. It is difficult to compete with the incumbent.
equation for marginal revenue in monopoly
MR = P + (ΔP/ΔQ) x Q Where ΔP/ΔQ will be a negative term. Therefore, MR will always be less than the market price
business strategies on monopolist
Marketing. Force distributors to sell your own product only. Deny access to an essential input/ infrastructure. Product differentiation.
is monopoly efficient
NO! Monopolies are not efficient, they result in a deadweight loss as compared to a competitive market
equation for marginal revenue linear
P = a - bQ MR = P + (ΔP/ΔQ) x Q MR = (a - bQ) + (-b)Q = a - 2bQ The only difference between the MR and TR curve is the slope, which is twice as steep for the MR curve.
equation for price in monopoly
Price = P + ΔP - where P is the market price.
what causes the deadweight welfare loss under market power?
Represents an Efficiency Loss - There are consumers in the market who are willing to buy the product at a price above its cost of production, but can't because the firm has hiked up prices to increase its profit. The size of the DWL depends on the difference between monopoly and competitive output levels. --> The more the firm withholds output, the greater the efficiency loss
Lerner index relation to market power
The firm with the high Lerner index has more market power than a firm with a low Lerner index value.
How do firms with market power profit max?
They choose profit maximising quantity where MC = MR. --> The price, however, depends on the height of the demand curve, so we read off price from the demand curve.
network good example of a switching cost
a good whose value to each consumer increases with the number of other consumers of the product i.e. Facebook
natural monopoly plus example
a market in which it is efficient for a single firm to produce the entire industry output i.e. electrical transmission companies
Lerner Index
a measure of a firm's markup, or its level of market power --> a rule of thumb for pricing that firms can use to determine profit-maximising prices and output levels.
barriers to entry
a source of market power: factors that prevent entry into markets with large producer surpluses
why would natural monopolies dissappear
demand can rise so much that average total cost rises enough for incumbents to allow new firms to enter the market
consumer switching costs type of barrier to entry
if customers have to give something up in order to switch to a competing product, this will generate market power for the incumbent and make entry difficult i.e. lose status of 'regular' on an airline / new satellite dish required for new network provider / cost of finding an alternative car
product differentiation example of a BARRIER TO ENRY AND source of market power + what that means for firms
imperfect substitutability across varieties of a product i.e. bicycle makes i.e. spatial product differentiation (where location matters because it is more appealing) THIS MEANS firms can price above competitors without losing all their sales
how does a monopoly differ from oligopoly and monopolistic competition
in oligopoly and monopolistic competition, the particular shape of the demand curve faced by any given firm depends on the supply decisions of the other firms in the market. in monopoly, the firm's demand curve is the market demand curve.
how can a monopoly sell more of a good / raise price
it must reduce its price / restrict output MR not equal to P
government intervention antitrust
laws designed to promote competitive markets by restricting firms from behaviours that limit competition
Markup (Lerner Index EQ) and range
left: mark-up right: Lerner index the percentage of the firm's price that is greater than its marginal cost - 0 for perfect competition, 1 for almost inelastic demand
what does the downward sloping demand curve mean for computing marginal revenue?
marginal revenue is no longer the price of the good like in perfect competition (P = MR) The firm experiences falling MR. Assuming firms cannot charge different prices to different customers, the more the firm chooses to sell, the lower the price will be for all units that it sells. When computing MR, the firm must also subtract the loss it suffers on every other unit.
oligopoly
market structure in which a few competitors operate
monopolistic competition
market structure with a large number of firms selling differentiated products
monopolist
the sole supplier of a good in a market without close substitutes. -The monopolist is a price setter, not price taker. - The monopolist has market power, i.e., an ability to influence the market price of a product
response to a change in consumers' sensitivity to price PC vs. MP (rotation of demand)
when PED INCREASES Perfect Competition: - This does not change the point at which P = MC, so neither price nor quantity moves. Market Power - In this case, the rotation in demand also moves the marginal revenue curve. --> Although the new demand curve crosses the marginal cost curve at the same quantity, MR2 intersects the marginal cost curve at a higher quantity than did MR1. THEREFORE output rises and price falls
