HL 2.11 Market Failure (Market power)

Law of diminishing marginal returns

As each additional unit of a variable input are added marginal product first begins to increase (specialization of labour)

- Then the marginal product will decrease ⇒ assumption that the fixed inputs remain fixed

- If physical capital is fixed then production CAN NOT increase indefinitely just by adding more variable input → Production is limited by the size of the building or amount of machinery

Diminishing marginal return:

Due to the confines of FOP → adding another unit will increase the total product but at a smaller rate than the previous

Profit (types + calculation)

Abnormal profit: TR>TC

Normal profit: TR = TC (break even)

Loss: TR

Marginal cost + marginal revenue (meaning, different points)

Marginal cost: the additional costs of producing one more unit of output

Marginal revenue: extra revenue from producing one additional good + service

MR = MC: profit maximization point (always produce)

- MR < MC: additional cost will be higher than additional revenue + produce less to earn more

- MR > MC: additional revenue is higher than additional costs = produce more to earn more

Average revenue and average costs

AR: same as price of goods and services

total revenue per unit

- AR=P

Average cost: TC/Q

- total cost of producing per unit

AR: TR/Q

- AR>AC = abnormal profit -> more revenue is generated than necessary to cover the expenses of production

- AR = AC: normal profit -> revenue covers all expenses

- AR

Total product (calc)

Total output produced by a firm

- AP x unit of input (usually labour)

marginal product

Additional unit of output per additional unit of input

- change in TP/ change in unit per variable of input

- MP = 0 -> total product is maximised (greatest total revenue point )

after MP peak marginal returns begin to set in

- When MP is positive = TP is increasing (vice versa)

average product

TP/unit of input

- intersects with MP, then decreases

- MP decreases = AP decreases

MP>AP = average is higher (vice versa)

Short run vs Long run

Short run = at least 1 FOP is fixed

Long run = all FOP are variable

Market Power (types of market structures)

How indivdual firms are able to control prices

- price taker vs price makers

1. Perfect competition

Imperfect competition: highest market power

2. Monopoly

3. Oligopoly

4. Monopolistic competition

Characteristics of market structures

Number of firms in the market

Product differentiation (identical or not)

Barriers to entry (how easy or difficult it is for new firms to enter/leave the market)

Degree of market power (price maker or price taker)

Productive efficient + allocative efficient

Productive: AC = MC

Allocative: MC = MR

Perfect competition (graph + types of profit + definition)

In highly competitive markets where firms have no control over price (price taker) ⇒ AR and MR are constant because price doesn't change

- Price is constant = MR constant

- no product differenciation

- many firms

- D=P=AR=MR

Profit:

abnormal

normal

loss

Perfect competition normal profit (graph, points, def, long run+ short run)

Cost = revenue -> profit maximising

- AR = AC

- MR = MC

- Profit = 0

allocative efficiency: MB = MC

-> MR, D, and AR are all represented by the same horizontal line

- firms produce (Q) where MC intersects MR

Perfect competition abnormal profit (SRAC)

1. first point MC = MR

2. second point AC AC)

- cost per item is lower than revenue

- because firms make money more firms will enter the market

Perfect competition abnormal profit (LRAC)

1. Price will decrease from p1 to p2, decreasing Q1 to Q2

2. new demand curve of D2 = AR2 = MR2 at p2, q2

- firms enter the market so price will decrease, shifting MR1 to MR to meet the new point of C (revenue is now the same as cost MC = MR)

- in the long run abnormal profit correct to normal profit

Perfect competition abnormal loss (SRAC)

- AC > AR

- MC > MR

1. first point is at MC = MR

2. second point, Quantity and AC become higher

- cost per item is higher than its revenue

- because firms make losses, some will exit the market

Perfect competition abnormal loss (LRAC)

- P1 moves to P2 + Q1 to Q2

- D1 = MR1 = MC2 -> moves up to D2 = MR2 = AR2 (meets with AC)

- Revenue + costs is the name -> fixes to normal profit

Monopoly

- Highest market power

- price makers

- high barriers to entry

- little compeititon (PED inelastic)

Types of barriers to entry in monopoly

1. Economies of Scale

- output increases, AC decreases

- LRAC is downward sloping

- cost decrease = larger firms, but too large can lead to bad management and poor communication

2. Brand loyalty:

- consumers are less willing to switch

3. Legal barriers:

- patents: granted for an inventions

- license: government granted to carry out role

- Copyright: publish work right

- Traded restrictions: limit imports + exports

4. Control resources:

- One firm control resources = other firms can't enter market

Normal profit (monopoly)

Profit maximisation = MC = MR

- AC intersects with Q

- Cost per item = same as revenue

- Profit = 0 (normal profit)

-> same graph for monopolistic competition

Loss (monopoly)

1. MC = MR

2. AC> AR (AC is above + not touching AR)

- cost per item is more tan the revenue

- loss = negative

Abnormal profit (monopoly)

1st point MR = MC

2nd AC is at a lower point (below D = AR)

AC < AR

MC = MR = 0 -> profit maximisation

- cost per item is lower than revenue

- positive profit

Market failure (monopoly)

- monopoly causes market failure as they produce less of a product than what is optimal for society

- because they are profit maximizing = MR = AR

- produce less than what is required so prices remain high

- higher price and lower quantity than what is optimal

Loss minimization (monopoly + allocative efficiency)

- ATC is above D= AR

- Pe touches AR (Qopt)

- Qlmin intersects with MR, D=AR, ATC

-> has welfate loss as they are producing less than the social opt (AR=MC)

- more producer surplus than consumer

- AC - Pe = loss per unit

Profit maximization (monopoly)

- AC - Pe = loss per unit

- ATC is lower than MR -> ATC is lower than production = profit

Quantity is at Qmax

- Q intersects with MC, ATC, D= AR

Revenue maximisation by monopolist

Revenue will sell where MR = 0

- greater quantity and lower price than the profit maximize (MC=MR)

- MC decreases first due to specialization

- price decreases from P1 to P2 = increase quantity

- AC is below AR=D

Natural monopoly (abnormal profit)

occurs in the long-run

- new firms can't enter eg. water, electric industries (only need 1)

- LRAC + LRMC

- graph illustrates both abnormal profit and loss

- Q1 intersects with LRAC is below AR (P1)

- firms revenue is more than their costs

- not ideal for consumers so the government can intervene and force the production of Q2

Loss:

- Q2, LRAC does above AR where line matches up with Q2, D and LRMC (P2) -> this is the optimal output

LRMC intersects with D = AR at q2, and intersects with MR above loss at q1

- higher costs than revenue for firms

- unsustainable in the long run so the government could assist the firms by providing subsidies that cover these losses

Monopolistic competition

Where many companies compete to sell similar but differentiated products.

- each company has a monopoly over its own product but is competing with firms in the same industry that have similar products.

Characteristics:

- large number of firms in the market

- Products are similar but differentiated in some ways (branding, packaging, features)

- Low barriers to entry and exit

- Price maker

- Some level of market power

- Dynamic efficiency: when all resources are allocated efficiently over time, and the rate of innovation is at the optimum level, which leads to a falling long-run average cost

Monopolistic competition product differentiation

Differences in quality

Physical differences

Different locations

Differences in services

Product image/branding

Abnormal profit (monopolistic competition SRAC)

1. MR = MC profit maximising

- Q1 -> AC is at point B while AR=D is at C

- cost per item is lower than revenue

- Firms make money, more will enter the market

Abnormal profit (monopolistic competition LRAC)

- more firms enter the market, price will decrease

- This means D=AR1 and MR1 shifts to D=AR2 and MR2 (down)

- Q is always at MR = MC -> revenue is the same as costs

- normal profit in the long run

Loss in monopolistic competition (SRAC)

1. produce at MR = MC -> point A intersects with Q1 and MR

2. Q, AC is at point B (above and not touching D=AR)

3. AR is at point C

-> firms will make a lose and some will exit the market

Loss in monopolistic competition (LRAC)

- because firms leave the market = price increases (P1-P2)

1. D=AR1, MR1 shifts up to D=AR2, MR2

- remember firms always produce at Q (MR=MC)

2. At Q, AC is the same level as AR (touching AR2)

- revenue is the same as costs = losses turn into normal profit

Allocative efficiency (monopolistic competition)

- price makers = produce less than what is optimal for society, price remains high to make a profit = welfare loss

- more firms, but has a smaller ability to create inefficiencies = smaller welfare loss than monopoly

- market can also produce variety = better choice for consumer

same graph as allocative efficiency monopoly

Oligopoly

Firms have a significant level of market power but they are itnerdependent due to the oligopolistic nature of the market

- There are a small number of firms that control the market

- Products can be identical like oil or differentiated like car

- High barriers to entry/exit

- Price makers

- Interdependent to predict what each other will do:

1. Price wars: The firms try and undercut each other, leading to unsustainably low prices

2. Collusion: The firms decide to increase prices together, leading to very high prices

3. Cheating: Despite laws preventing firms from colluding, they might still do so in order to make lots of abnormal profit

2 types of oligopoly:

Collusive: The firms decide to team up and set similar prices, so they all benefit from higher prices

Non-collusive: The firms do not team up, and compete against each other

- same as a monopoly graph (but Q is labelled as Q/n -> n is number of firms in the market)

Allocative efficiency (oligopoly)

- the firms decide to team up and essentially act as a single entity, a monopoly.

- they have the market power to set produce their profit maximizing quantity, meaning allocative efficiency is not reached.

= welfare loss

Same as monopoly

Game Theory Payoff Matrix

- shows how collusion may result in different outcomes = end up hurting the colluding firms

- both firms have the incentive to cheat to earn money but they will both lose = best to just confess

-> eg. A confess + B confess (both 5 years)

- A confess + B deny (B= 0 years, A = 15y)

- A deny, B confess (A=0years, B=15 years)

- Both deny = 2 years

Competition in Oligopolies

Price Competition: different firms try and make the price of their products as appealing as possible

Non-price Competition: compete in other variables, eg. quality, design, aesthetics, and trends = differentiated products

Market Concentration

market concentration of an industry refers to the distribution of the firms in the given market.

- very few firms = high market concentration

- many firms = low market concentration

A market concentration can be measured using a concentration ratio - The market share a specified number of firms (usually 5) have over an industry

Advantages of Firms Having Significant Market Powe

Economies of scale:

- firm grows, the per-unit cost of producing a good decreases = increased expertise, bigger factories, supplies bought in bulk, etc., all of which lead to greater efficiency.

Investment:

- Abnormal profits firms make could be used for investment into Research & Development (R&D) = innovation.

Risks in Markets Dominated by a Few Large Firms

Less output:

When firms control the market, they choose to reduce their output compared to the socially optimum quantity in order to maximize profits = creates a welfare loss.

Higher prices: Because output is reduced = prices increase, and be higher than the socially optimum price.

Less consumer choice: few firms = consumers have less choice of what to purchase.

Government Intervention in Response to Abuse of Market Power

Legislation & regulation:

- prevent firms from becoming too big,

eg. blocking big mergers of companies

Government ownership: Government-owned monopolies can be made so they produce at a socially optimum output

Fines: The government can fine large firms for being too big, known as "antitrust"