market power and monopoly copyright © 2013 worth publishers, all rights reserved microeconomics ...

Market Power and Monopoly

Copyright © 2013 Worth Publishers, All Rights Reserved Microeconomics Goolsbee/Levitt/ Syverson 1/e

9

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Chapter Outline

9.1 Sources of Market Power9.2 Market Power and Marginal

Revenue9.3 Profit Maximization for a Firm

with Market Power9.4 How a Firm with Market Power Reacts to Market Changes9.5 The Winners and Losers from

Market Power9.6 Governments and Market Power: Regulation, Antitrust, and Innovation9.7 Conclusion

9-1

Introduction

Copyright © 2013 Worth Publishers, All Rights Reserved Microeconomics Goolsbee/Levitt/ Syverson 1/e 9-2

9In the real world, there are very few examples of perfectly competitive industries

Firms often have market power, or an ability to influence the market price of a product

The most extreme example is a monopoly, or a market served by only one firm•A monopolist is the sole supplier (and price setter) of a good within a market

Firms with market power behave in different ways than those in perfect competition

9.1


The key difference between perfect competition and a market structure in which firms have pricing power is the presence of barriers to entry• Factors that prevent entry into markets with large producer surpluses• Normally, positive producer surplus in the long run will induce additional firms to enter the market• The presence of barriers to entry means firms may be able to maintain positive producer surplus indefinitely

9Sources of Market Power

9.1


Extreme Scale Economies: Natural Monopoly

One common barrier to entry results from a production process that exhibits economies of scale at every quantity level• Long-run average total cost curve is downward sloping; diseconomies never emerge

Results in a situation called a natural monopoly• More efficient for a single firm to produce the entire industry output

• Splitting output across multiple firms raises the average cost of production• Consider a production process with the following total cost structure

What are some examples of industries that might exhibit continuously declining average total costs as output increases?


9.1



Application


Switching Costs and Retail Gasoline Margins

In the 1980s, retail margins for unleaded gas exceeded those of leaded gas, despite identical wholesale costs

Borenstein (1991) examined alternative hypotheses•Differences in costs of selling to different customers•Differences in fixed costs of providing leaded vs. unleaded•Price discrimination

He finds that the likely culprit is price discrimination•Buyers of unleaded gas tend to have higher income, thus there is lower price elasticity of demand, and higher search costs associated with finding an alternative seller •Hypothesis supported by decline in leaded gas availability from 1985 onward, which increased leaded gas search costs and was associated with a decline in the relative unleaded margin

Images: FreeDigitalPhotos.net

9

Citation: Borenstein, S. 1991. Selling Costs and Switching Costs: Explaining Retail Gasoline Margins. RAND Journal of Economics 22(3): 354–369.

9.1


Product Differentiation

For most noncommodity markets, consumers may not treat products from different firms as perfect substitutes• Example: Burger King and Chipotle compete for fast-food customers, but their products are highly differentiate. How?

Product differentiation refers to a situation in which there is imperfect substitutability across varieties of a product


9.1


Absolute Cost Advantages or Control of Key Inputs

Many production processes rely on scarce inputs (e.g., natural resource products)• For instance, Saudi Aramco (Saudi Arabia’s state-run oil company) maintains control over a vast oil supply, with relatively low extraction costs

In other circumstances, firms may develop absolute cost advantages by engaging in long-term contracts with intermediate suppliers• Apple has developed this type of relationship with Foxconn, a Chinese company that assembles many of Apple’s products


9.1


Government Regulation

A final important barrier is the presence of government regulation that limits entry to a market•Patents•Licensing requirements (e.g., medical board certification)•Prohibition of competition (e.g., U.S. Postal Service)


Application


Airline Deregulation and Price Competition

From 1937 to 1978, the Civil Aeronautics Board (CAB) regulated all interstate air transport as a public utility•Fares, routes, and schedules were all set by bureaucrats and airlines were regulated in a manner similar to utilities•Short-haul fares were generally subsidized by higher long-haul fares to encourage commercial air travel•In 1978, the Airline Deregulation Act was passed, removing government control in an attempt to promote competition

What types of effects should we expect from deregulation?


9

Citation: Kahn, A. E.. 1988. Surprises of Airline Deregulation. American Economic Review Papers and Proceedings 78(2): 316–322.

Application


Airline Deregulation and Price Competition

First, competition exploded•Low-cost carriers entered the market, driving down the price-per-mile for most routes; fares dropped 30% by 1990•Long-haul fares in particular saw significant drops in price, while short-haul fares remained relatively flat•Profit margins and wages declined; many bankruptcies

However, a number of surprising consequences•The emergence of “hub-and-spoke” networks: more operationally efficient, but has limited competition at hubs•Frequent-flyer programs, airline partnerships, and mergers have maintained market power•Price competition has led to declines in quality of service and increased hidden fees as airlines attempt to pad margins


9

Citation: Kahn, A. E.. 1988. Surprises of Airline Deregulation. American Economic Review Papers and Proceedings 78(2): 316–322.

9.2


9Market Power and Marginal Revenue

9.2


Marginal Revenue

In perfect competition, the demand curve facing an individual firm is horizontal, and marginal revenue is equal to price

If a firm has market power, the demand curve for its product(s) will have a downward slope

What does this imply for the shape of the marginal revenue curve?

Consider the production decisions of Durkee-Mower, Inc., a Massachusetts firm that makes Marshmallow Fluff •Has had a dominant market position since the 1920s•Table 9.1 shows how price and marginal revenue are related to the quantity of Fluff produced


9.2



9.2


It is important to note that marginal revenue is not equivalent to price for a firm facing a downward-sloping demand curve

Why is this the case?

•When a firm produces more of a product, the price for all of its product in the marketplace falls•This occurs because we are considering a specific market (time/place); decisions are not sequential, firms cannot price-discriminate•Price discrimination is a pricing strategy in which firms with market power charge different prices to customers based on their willingness to pay

Marginal revenue is the change in total revenue associated with an increase in output; two components for a firm with market power•Increase in total revenue associated with an increase in sales•Decrease in total revenue associated with the fall in market price for all previously produced units of output


9.2



Figure 9.1 Understanding Marginal Revenue

Price Revenue lost fromincreasing outputRevenue gained fromx

increasing outputP1 A yP2B C

DemandQuantityQ1 Q2

Revenue unchanged

9.2


The two opposing affects on marginal revenue associated with an increase in production by a monopolist can be examined mathematically

1.The additional revenue from selling one more unit at market price

2.The fall in revenue associated with a decline in market price for all units produced

Combining these affects gives the equation for marginal revenue:


9.2


Consider what the equation for marginal revenue means

1.Marginal revenue is always less than price for every unit produced

2. is the slope of the demand curve; if steep, consumers are not price sensitive, and marginal revenue falls rapidly as price increases

3.As quantity increases, the second affect (the lower price for all other units produced) becomes more important to total revenue

Consider a linear demand curve ( is constant)

The inverse demand curve is given by , therefore:



figure it outComputing Marginal Revenue

Suppose the demand for a product is given by

Answer the following questions:a.Find the marginal revenue curve associated with this demand curve

b.Calculate marginal revenue when the firm produces three and five units of output, respectively


figure it outComputing Marginal Revenue

a. First, solve for the inverse demand curve

The equation for the marginal revenue for a linear demand curve is:

b. Plugging in Q = 3 yields:

and Q = 5 yields:

As output increases, marginal revenue falls, and, eventually, producing more will result in lower total revenue

9.3


How to Maximize Profit

Firms with market power are still assumed to maximize profits •However, unlike perfect competition, production decisions influence price

How much will firms choose to produce?

•Answer: they will engage in production until

Will a monopolist produce more or less than the aggregate production in an identical, perfectly competitive industry?

9Profit Maximization for a Firm with Market Power

9.3


Profit Maximization: A Graphical Approach

Consider the market for iPads; assume that the marginal cost of production for Apple is constant at $200 per unit

There are three steps to determining the profit-maximizing quantity of production

1.Derive the marginal revenue curve from the demand curve

2.Find the output quantity at which marginal revenue equals marginal cost

3.Determine the profit-maximizing price by locating the point on the demand curve at the optimal quantity level


9.3


9Figure 9.3 How a Firm with Market Power Maximizes

Profit

Profit Maximization for a Firm with Market Power

Price($/iPad)P * = $600

200 MCD0 Quantity of iPadsQ* = 80 (millions)MR

Profit is maximized when marginal revenue is equal to marginal cost.

9.3


Profit Maximization: A Mathematical Approach

Consider again the market for iPads; the marginal cost of production for Apple is constant at $200 per unit; now suppose demand is given by

where quantity is measured in millions and price in dollars

How do we determine the profit-maximizing price–quantity combination that Apple should choose?


9.3



1.Derive the marginal revenue curve from the demand curve

This is a linear demand curve, so marginal revenue takes the form


0.2 200 1,000 5P Q P Q

2 1,000 10MR a bQ Q

9.3



2.Find the output quantity for which marginal revenue is equal to marginal cost

For this step, simply set the equation for marginal revenue equal to $200, solving for quantity

3.The profit-maximizing price can be found by substituting the profit-maximizing quantity into the inverse demand curve


1,000 10 200 80 millionMR MC Q Q

1,000 5(80) $600P

9.3


A Markup Formula for Companies with Market Power: The Lerner Index

It is useful to have a general approach to determining the rate of markup for firms with market power

Markup is the percentage of a firm’s price that is greater than its marginal cost

The Lerner Index is a measure of a firm’s markup, which indicates the degree of market power the firm enjoys


9.3


A Markup Formula for Companies with Market Power: The Lerner Index

Starting with the definition of marginal revenue, and setting it equal to marginal cost

Multiply the left-hand side by P/P (doesn’t change anything)

And finally,

or, as demand becomes more elastic, the optimal markup fallsWhy does this make sense?


9.4


Response to a Change in Marginal Cost

Just as in the case of a firm in a perfectly competitive industry, firms with market power will alter output decisions in response to changing marginal costs of production

Suppose an accident at the factory of an Apple parts supplier leads to an increase in the marginal cost of iPad production from $200 to $250 per unit

How will this affect Apple’s production decisions?

9How a Firm with Market Power Reacts to Market Changes

9.4


9Figure 9.3 How a Firm with Market Power Reacts to

an Increase in Marginal Cost

How a Firm with Market Power Reacts to Market Changes

Price($/iPad)$1,000

dP2 = 625P1 = 600c250 MC2200 MC1a DMR0 Quantity of iPadsQ2 = 75 (millions)

b

Q1 = 80

9.4


Response to a Change in Demand

Now suppose there is an outward shift in the demand for iPads due to an expansion of their use by the medical industry

The new inverse demand curve is given by

To find the new, profit-maximizing price–quantity combination, follow the same three-step procedure


9.4



1.Derive the marginal revenue curve from the inverse demand curve

Marginal revenue takes the form

2.Find the output quantity for which marginal revenue is equal to marginal cost


1,400 10 200 120 millionMR MC Q Q

9.4



3.The profit-maximizing price can be found by substituting the profit-maximizing quantity into the inverse demand curve

So, an outward shift in demand increases both the quantity of iPads produced and the price at which each is sold



figure it outResponding to Changes in Demand

The Power Tires Company has market power and faces the demand curve shown in the figure below. The firm’s marginal cost curve is

Answer the following questions:a.What is the firm’s profit-maximizing output and price?

b.If the firm’s demand declines to P = 240 – 2Q, what is the firm’s profit-maximizing level of output and price?

QMC 330



P a bQ

QQP 3300100

300300



The marginal revenue curve is given by

yielding

Profit maximization occurs where MR = MC, or

And the price

b. When demand falls to P = 240 – 2Q, we have

bQaP 2

QMR 6300

30

9270

3306300

Q

Q

QQ

210$3300 QP

180$

30

3304240

P

Q

QQMR

9.4


Changing the Price Sensitivity of Consumers

A major way in which firms with market power react differently than those subject to perfect competition is in response to changes in the price sensitivity of demand

For instance, consider what happened to the demand for iPads when Amazon introduced its Kindle Fire tablet computer•Demand for iPads should have become more price-elastic•The demand curve for iPads should have had a shallower slope


9.4


9Figure 9.4 Responses to a Rotation in the Demand

Curve

How a Firm with Market Power Reacts to Market Changes

(a) Perfect competition (b) Market powerPrice Price( $/unit) ( $/unit) MCS

D2 D2

D1 MR1 MR2Quantity QuantityQc*D1

The shape of the demand curve does not matter in perfect competition, only the intersection with the supply curve.


figure it outMarket Power

Suppose the local roofing company has market power and faces the following inverse demand curve

where quantity is the number of roof jobs, and price is in dollars. The marginal cost for this firm is

Answer the following questions:a. What is the profit-maximizing output and price?

b. If the firm’s demand declines to , what is the new profit-maximizing output and price?

2,000 10P Q

1,400 12P Q



a. Derive the marginal revenue curve from the inverse demand curve

Marginal revenue takes the form

Setting marginal cost equal to marginal revenue

So, the profit-maximizing quantity is 50. To find the price, use the inverse demand curve

The profit-maximizing price is $1,500

2,000 10P Q

2 2,000 20MR a bQ Q

2,000 20 200 16 1,800 36 50Q Q Q Q

2,000 10 50 $1,500P



b. Now, perform the same calculations with the new inverse demand curve

Marginal revenue is

Setting marginal cost equal to marginal revenue

The profit-maximizing quantity is 30, and there has been a reduction in demand. Using the inverse demand curve,

And the profit-maximizing price is $1,040

1,400 12P Q

2 1,400 24MR a bQ Q

1,400 24 200 16 1,200 40 30Q Q Q Q

1,400 12 30 $1,040P

9.5


If firms with market power find it profitable to choose a level of output that is different from that which would occur in perfect competition, there must be some additional benefit

How much better off are firms when they have market power, and what does this imply for consumers’ well-being?

9The Winners and Losers from Market Power

9.5


Consumer and Producer Surplus under Market Power

Returning to the example of Apple and the iPad, recall that Apple has a marginal cost of production of $200 per unit and faces inverse demand

where quantity is measured in millions

Producer surplus is the difference between the monopoly price of iPads and the constant marginal cost, multiplied by the quantity sold


1,000 5P Q

9.5


Consumer and Producer Surplus under Market Power

Consumer surplus is calculated as the area under the inverse demand curve and above the sales price

First, calculate the demand choke price, which is the price at which quantity demanded is equal to zero

With linear demand, consumer surplus is a right triangle with height equal to the demand choke price net of the sales price, and length equal to quantity sold


1,000 5 0 $1,000P

choke

1 1$1,000 $600 $80 million $16 billion

2 2m mCS P P Q

9.5


Consumer and Producer Surplus under Perfect Competition

How would the outcome of the market for iPads change under perfect competition?

In perfect competition, marginal cost is equal to industry supply, and equilibrium occurs when industry supply is equal to demand

And price is equal to $200

What happens to Apple’s profit?

Consumer surplus becomes


1,000 5 200 160 millionP MC Q Q

choke

1 1$1,000 $200 160 million $64 billion

2 2c cCS P P Q

9.5


9Figure 9.5 Surplus from the Apple iPad

The Winners and Losers from Market Power

Price Consumer surplus (competition) =A+ B + C($/iPad) Producer surplus (competition) = 0Consumer surplus (market power) = AProducer surplus (market power) = B$1,000 Deadweight loss from market power=CA Market power, mPm = 600

Competition, cB CPc = 200 MCD0 Quantity of iPadsQm = 80 Qc = 160 (millions)

9.5


The Deadweight Loss of Market Power

Producer surplus is eliminated under perfect competition, but consumer surplus increases

Also, net surplus improves under perfect competition, from $48 billion to $64 billion

This illustrates the loss in efficiency that accompanies markets that are not perfectly competitive•When producers have market power, they can improve their outcomes•However, by reducing output to a level below the perfectly competitive level, total surplus falls

This loss of efficiency is a deadweight loss, and in this case is equal to $16 billion


9.5


9Figure 9.6 Gains from Market Power under Different

Demand Curves

The Winners and Losers from Market Power

(a) Less elastic demand (b) More elastic demandPrice Price( $/unit) ( $/unit)

P1P2PS1 PS2MC MCMR2MR1 D1Quantity QuantityQm Qm

D2


figure it outDeadweight Loss and Market Power

Joe’s Garage (JG) faces inverse demand curve P = 120 – 10Q, and marginal cost curve MC = 20, where quantity is measured in rotations per day and price in dollars.

Calculate the deadweight loss from market power at the firm’s profit-maximizing level of output


Figure it outDeadweight Loss and Market Power

The easiest way to find deadweight loss is through the use of a diagram.

Price Consumer surplus (competition) =A+ B + C($/rotation) Producer surplus (competition) = 0Consumer surplus (market power) = AProducer surplus (market power) = B$120 Deadweight loss from market power=CA Market power, mPm = 70

Competition, cB CPc = 20 MCD0 Quantity of rotationsQm = 5 Qc = 10 (per day)MR


figure it outDeadweight Loss and Market Power

The easiest way to find deadweight loss is through the use of a diagram.

The profit-maximizing level of output is 2,500 bats sold at a price of $18.75. To find the deadweight loss, we need to consider producer and consumer surplus and compare it with the competitive outcome. If BB was competing in a competitive market, it would set marginal cost equal to price

33.3

55.225

Q

QQ

MCP


Figure it outDeadweight Loss and Market Power

The profit-maximizing level of output for JG is 5 rotations per day at a price of $70 per rotation. If JG were operating in a competitive market, it would offer 10 rotations per day at $20 per rotation (price equal to marginal cost).

The deadweight loss associated with market power is equal to the difference in total surplus between the competitive and monopoly situations.

In this example, it is a right triangle with length of 5 and height of 50

9.6


The deadweight loss associated with market power can justify government intervention if regulations help achieve a more competitive or efficient outcome

Direct Price Regulation

In some cases, the government will regulate price rather than attempting to dismantle a monopoly or encourage new participants•This is often the case for natural monopolies, or industries in which a firm’s long-run average total cost falls continuously as output increases

Consider a utility that provides electricity to a town•Significant fixed costs (generation and transmission)•Low marginal costs

9Governments and Market Power: Regulation, Antitrust, and Innovation

9.6


9Figure 9.7 Government Regulation of a Natural

Monopoly

Governments and Market Power: Regulation, Antitrust, and Innovation

Price($/kwh)A mPm B LATCCPc c LMCDMR Quantity ofQm Qc electricity (millionsof kilowatt-hours)

What happens if a regulator forces the utility to provide the “efficient” level of electricity (where LMC = demand)?

9.6


Antitrust laws are designed to promote competitive markets by restricting behaviors that limit competition• Mergers and acquisitions• Price-fixing and other forms of collusion• Predatory pricing

Can be difficult to determine if concentration is bad for consumers

In other cases, the government may actually promote monopolies• Patents, licenses, copyrights• Designed to spur innovation• In setting length of patents, must balance the incentive for innovation with the reduction in consumer welfare that comes with granting a monopoly

Rent-seeking is a firm’s attempts to gain government-granted monopoly power and, therefore, additional producer surplus

9Governments and Market Power: Regulation, Antitrust, and Innovation

9.7


In this chapter, we have shown how firms with market power don’t treat output price as fixed, but instead recognize that price depends on the quantity of product produced• Firms produce where marginal cost is equal to marginal revenue• Equilibrium output is lower than under perfect competition• Leads to a deadweight loss

However, we have so far assumed that to sell more of a product, a firm must lower the price on all previously produced units

In Chapter 10, we examine how firms may be able to charge different prices to different consumers, a practice called price discrimination

9Conclusion

market power and monopoly copyright © 2013 worth publishers, all rights reserved microeconomics ...

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