Economics Unit 2.11 - Market Power

monopoly

a market structure where a single firm dominates and has significant price setting power due to a lack of competition

monopoly market key features

- single or dominant firm: one firm controls the entire (or nearly entire) market, often legally or structurally

- high barriers to entry: new firms are prevented from entering due to factors such as high start-up costs, economies of scale, legal protections (eg. patents), branding, or control over key resources

- no close substitutes: consumers have no real alternatives, giving the firm significant control over pricing

abnormal profit

- occurs when average revenue is greater than average cost (AR>AC) at the profit maximising output (MR=MC)

- total profit = Q* x (P1 - AC)

- unlike perfectly competitive firms, monopoly firms can sustain abnormal profit in the long run due to high barriers to entry which prevent new firms from entering the market and decreasing profit over time.

loss

- occurs when average revenue is less than average costs (AR

market failure (reminder)

occurs when an unregulated market is un able to allocate scarce resources efficiently, leading to an over-allocation of resources towards the production some goods and services or an under-allocation of resources towards certain markets

allocative inefficiency (monopoly market failure)

- monopolies produce at profit-maximising level of output where MR=MC, not where price (AR) = MC

- as such, the value consumers place on the good (price) is greater than the cost of producing it, indicating not enough of the good is being produced by the market

- as such there is an underallocation of resources

welfare loss (monopoly market failure)

- monopolies restrict output and charge a higher price compared to perfect competition, creating a deadweight loss in there market

- represents the loss of consumer surplus

higher prices / lower output (monopoly market failure)

- monopolies typically restrict output to raise prices and maximise profit

- results in Lowe consumer surplus and reduced access to goods and services

- higher price / lower quantity compared to a perfectly competitive market

productive inefficiency (monopoly market failure)

- monopolies may not produce at lowest point on average cost curve (AC), as such are not minimising costs

- lack of competition reduces the incentive to cut costs and operate efficiently

natural monopoly

- occurs when one firm can supply the entire market at a lower average cost than multiple firms, due to significant economies of scale

- most common in industries with high fixed costs and low marginal costs (eg. water/electricity), where competition would lead to higher costs and inefficiency

economies of scale

- refers to the cost advantages a firm experiences as it increases its output

- as production expands, AC per unit falls, making it more efficient for one large firm to serve the entire market than multiple smaller, competing firms

- happens as firms can spread its high fixed costs (eg. infrastructure) across a large quantity of units

economies of scale (strength of significant market power)

in some cases, this can lead to a natural monopoly, where one firm can supply the entire market more efficiently than multiple smaller firms due to very high fixed costs, and falling average costs over a wide range of output

R&D and innovation (strength of significant market power)

- abnormal profit ,may be reinvested into research and development, leading to innovation, product improvement or cost reducing technologies

- may benefit consumers over time through lower prices and higher quality

- may improve productivity int he economy over time

oligopoly

a market dominated by a few large firms, often resulting in strategic behaviour and limited price competition

oligopoly key features

- few large firms: each firm holds significant market share, making them mutually interdependent

- high barriers to entry: may include high start-up costs, economies of scale, brand loyalty and resource control

- interdependence: firms must consider the likely reactions of rivals when making pricing or output decisions, often leading to price rigidity or collusion

market concentration

- the degree to which a market is dominated by a number of firms

- measured by concentration ratio

concentration ratio

= total sales of an individual firm / total market sales

interdependence (oligopoly characteristic)

- firms are few in number, so each firm's actions significantly affect rivals

- pricing, output or advertising decisions must consider likely reactions or competitors

- creates strategic behaviour, decisions are interdependent rather than independent

risk of price war (oligopoly characteristic)

- if one firm cuts prices to gain market share, rivals are likely to retaliate, leading to a destructive price war

- this reduces profits for all firms, often driving prices closer to the marginal cost

- this risk provides a strong incentive to avoid competing on price

incentive to collude (oligopoly characteristic)

- firms may could (formally through cartels, or tacitly) to avoid price wars

- by agreeing to restrict output or fix prices, firms behave like a monopoly and share monopoly profits

- collusion is attractive because it raises prices and profits while reducing uncertainty

incentive to cheat (oligopoly characteristic)

- even in collusion, each firm has a temptation to secretly cut price our expand output to capture more market share

- this undermines collusion, as seen in the prisoner's dilemna

- stability of cartels depends on trust, monitoring and legal enforcement

allocative inefficiency / market failure (oligopoly characteristic)

- both collusive and non-collusive oligopolies tend to restrict output below the socially optimal level (P = MC)

- creates underallocastion of resources, loss of consumer surplus and welfare loss

prisoner's dilemma

- two rational decision-makers who use strategic behaviour to maximise profits by trying to guess the rival's behaviour, may end up being collectively worse off

- while collusion maximises joint profit, each firm has an incentive to cheat for individual gain (greater market share = greater profits), however if both cheat they are worse off than if they had colluded

oligopoly non-price competition

- aims to increase market share through product development, advertising, branding, customer services, etc

- due to significant financial resources, oligopolistic firms can invest heavily in R&D, making demand less elastic, raising market power and profit potential

- product differentiation can strengthen a firm's position without provoking immediate retaliation, since rivals need time and resources to develop competing products

collusive oligopoly

- firms cooperate either formally (through a cartel) or tacitly (implicitly following a price leader or highest market share)

- this reduces competition, acting as if a monopoly

- aim is to maximise joint profit and reduce uncertainty, but often leads to higher prices, lower output and allocative inefficiency

- diagram is same as monopoly

cartels

a formal agreement between firms in an industry to take actions to limit competition in order to increase profits

non-collusive oligopoly

- firms compete without any explicit or implicit agreement to coordinate behaviour

- firms act independently, but remain interdependent, as each must consider the reactions of rivals when making decisions

- often results in price rigidity and greater focus on non-price competition

non-collusive oligopoly price stability

- if a firm raises its price, rivals are unlikely to follow, as they can capture market share by keeping prices low, leaving the price-increasing firm worse off

- if a firm cuts its price, rivals are likely to respond with their own price cutest defend market share, reducing profit for all firms

monopolistic competition

a market structure with many competing firms, but each selling differentiated goods. Lies between perfect competition and monopoly in terms of the degree of competition and market power

monopolistic competition key features

- many firms: like in perfect competition, there are many sellers, each with a small market share

- free entry and exit: there are low barriers to entry so new firms can enter the market easily in the long run

- product differentiation: each firm offers a product that is similar but not identical to others, giving firms some price-making ability

profit maximisation in short run (monopolistic competition)

can make abnormal profit in short run because product differentiation gives firms some market power to set above marginal cos, allowing AR to exceed AC at Q*

profit maximisation in long run (monopolistic competition)

- low barriers to entry attract new firms when abnormal profits exist

- as new firms enter, demand for each existing firm's product falls

- entry continues until only normal profit is earned

- in the long run, firms still have some market power but profits are reduced to normal levels

allocative inefficiency (monopolistic competition)

- occurs when P=MC, however P>MC in both short and long run for monopolistically competitive firms due to product differentiation and downward-sloping demand

- results in an under allocation of resources to each firm's product compared with perfectly competitive outcome, creating a welfare loss

benefits of a monopolistically competitive firm

- compared to a monopoly:

- less inefficiency (demand curve is more elastic so prices are closer to MC)

- greater product variety (product differentiation allows consumers to choose based on quality, brand, style, location and other non-price factors)