ppt Microeconomics: Market Power and Imperfect Competition Study Guide

Market Power: Definitions and Barriers to Entry

Price Takers vs. Price Setters: Firms in perfect competition are price takers with no market power. Conversely, companies with market power are known as price setters or price makers. These firms choose the prices they charge and employ pricing strategies to increase and maintain long-term profits.
The Role of Barriers to Entry: For a firm to sustain profits in the long term, there must be barriers to entry that prevent or deter competitors from entering the market. These barriers are categorized into three types: technological, legal, and strategic.
Technological Barriers: These are inherent to the production process and include:
- Control over Essential Inputs or Exclusive Knowledge: Ownership of a vital resource (e.g., De Beers in the diamond trade) or exclusive formulas and source codes (e.g., Coca-Cola, proprietary software).
- Dealership and Distribution Contracts: Exclusive agreements, such as those between car manufacturers and dealers or breweries and cafes.
- Learning Costs: Occur when production costs decrease as historical cumulative production volume increases.
- External Growth: Expansion through mergers, acquisitions, and takeovers increases industry concentration. Governments monitor these to prevent excessive monopoly power; an example is the concentration seen in the global beer industry where companies like AB InBev have acquired brands ranging from Budweiser and Corona to craft labels.
- Network Effects: These occur when consumers experience positive effects as more users choose the same product.
  - Direct Network Effects: Value increases with the number of users (e.g., Facebook, Instagram, X).
  - Indirect Network Effects: Occur in platforms where the value for one user group depends on the size of another user group (e.g., advertisers and readers in newspapers).
Economies of Scale and Natural Monopolies: In some sectors, production is only efficient if a single firm exists because the average cost (AC) declines over the entire market size.
- Natural Monopoly Condition: If one firm produces a quantity $2q^*$ , the total cost is lower than if two separate firms each produced $q^*$ .
- Examples: Industries with high fixed costs like automotive production, banking, and communications.
Legal Barriers: Governments may grant exclusive selling rights through:
- Patents: Protection for inventions for approximately 20 years to incentivize research and development (e.g., pharmaceuticals).
- Copyrights: Ownership of creative works like text, images, films, and software to prevent copying.
- Establishment Laws: Regulations limiting the number of practitioners (e.g., pharmacists or notaries).
- Exclusivity Rights: Granted in exchange for social services (e.g., national postal or rail services).
Strategic Barriers: Incumbent firms use specific behaviors to deter entry:
- Threat of Lawsuits: Protecting patents against imitations.
- Entry Limit Pricing: Charging a price lower than the profit-maximizing level to make entry unattractive to newcomers.
- Predatory Pricing: Temporarily setting prices below average cost to eliminate a entry threat, accepting a short-term loss to secure long-term power.

Monopoly Theory and Output Choice

Characteristics of a Monopoly: A single company serves or dominates the entire market. The market supply equals the monopolist's supply, and the commodity has few substitutes.
Profit Maximization Rules: Monopolists follow two fundamental rules:
- Output Rule: Produce where marginal revenue equals marginal cost ( $MR = MC$ ).
- Shutdown Rule: In the short run, shut down if $p < AVC$ . In the long run, shut down if $p < AC$ .
Demand and Marginal Revenue: Unlike perfectly competitive firms that face a horizontal demand curve, a monopolist faces a downward-sloping market demand curve. Since the monopolist must lower the price to sell more units, the $MR$ curve lies below the demand curve.
Quantitative Example: Sandwich Producer:
- Demand: $Q(p) = 600 - 100p$
- Inverse Demand: $p(Q) = 6 - 0.01Q$
- Total Revenue ( $TR$ ): $TR(Q) = p \times Q = 6Q - 0.01Q^2$
- Marginal Revenue ( $MR$ ): $MR(Q) = 6 - 0.02Q$
- Assuming constant costs: $AC = AVC = MC = 2$
- Equating $MR = MC$ : $6 - 0.02Q = 2 \rightarrow Q = 200$
- Price: $p = 6 - 0.01(200) = 4$
- Profit: $(p - AC) \times Q = (4 - 2) \times 200 = 400$
The Mark-up: The ratio of price to marginal cost ( $p/MC$ ) indicates market power. In this example, the mark-up is $4/2 = 2$ . Monopolists operate only on the elastic portion of the demand curve where $MR > 0$ .

Welfare Analysis of Monopoly

Efficiency Comparisons: Monopolies result in lower welfare than perfect competition. In the sandwich example:
- Perfect Competition: equilibrium occurs where $p = MC$ ( $p=2, Q=400$ ). Consumer Surplus ( $CS$ ) is $\frac{1}{2} \times (6 - 2) \times 400 = 800$ . Producer Surplus ( $PS$ ) is 0.
- Monopoly: $p=4$ , $Q=200$ . $CS$ is $\frac{1}{2} \times (6 - 4) \times 200 = 200$ . $PS$ is $(4 - 2) \times 200 = 400$ . Total Welfare is $600$ .
- Deadweight Loss (DWL): The reduction in welfare ( $800 - 600 = 200$ ). This represents mutually beneficial transactions that do not occur because the monopolist restricts output to keep prices high.
Rent-seeking: Monopolists may spend their profits on influencing policymakers to protect their position. This is considered an additional efficiency loss.
Dynamic Gains: While monopolies cause static efficiency losses, they may provide dynamic efficiency gains by using profits to fund innovation, which is the justification for temporary patent protections.
Regulation of Monopolies:
- Marginal Cost Pricing: Setting $p = MC$ maximizes welfare but can lead to losses for natural monopolies where $p < AC$ .
- Average Cost Pricing: Setting $p = AC$ allows the firm to break even (zero profit) and requires fewer subsidies than marginal cost pricing, though it still involves some welfare loss compared to the perfect competition outcome.

Price Discrimination

Definition: The strategy of selling the same product at different prices to different customers based on their willingness to pay (WTP).
Requirements:
1. Identifiable consumer types with different WTP values.
2. Prevention of resale between consumers.
Types of Price Discrimination:
- Perfect (1st Degree) Price Discrimination: The firm charges every consumer their exact maximum WTP.
  - The $MR$ curve coincides with the demand curve.
  - $CS$ is reduced to zero, and the producer captures the entire total surplus.
  - This outcome is efficient ( $DWL = 0$ ) because the firm produces the same total quantity as in perfect competition ( $p=MC$ at the margin).
- Market Segmentation (3rd Degree): Dividing customers into groups with different price elasticities.
  - Direct Segmentation: Based on measurable traits like age or student status (e.g., student movie tickets). The group with more inelastic demand (e.g., adults) pays a higher price than the elastic group (e.g., students).
  - Indirect Segmentation (Self-Selection): Consumers choose from a menu of options (e.g., business vs. economy airfare). Business travelers pay more for flexibility because they are more price-inelastic.
- Intertemporal Price Discrimination: Charging different prices based on the timing of the Purchase (e.g., sales periods or "skimming" where prices start high for early adopters and drop later).

Measuring Market Power and Concentration

Mark-up Analysis: In perfect competition, the mark-up ratio ( $P/MC$ ) is 1. Higher ratios indicate more market power. Globally, mark-ups have increased significantly over the last 40 years, rising from around 1.1-1.2 in the 1980s to approximately 1.6-2.0 today.
Concentration Statistics:
- C4 Standard: The sum of the market shares of the four largest firms. A value of 100 indicates a monopoly or duopoly.
- Herfindahl-Hirschman Index (HHI): The sum of the squared market shares of all firms.
  - Formula: $HHI = s_1^2 + s_2^2 + \text{...} + s_n^2$
  - Monopoly: $100^2 = 10,000$ .
  - Competitive Policy Benchmark: Often triggers investigation if $HHI > 1800$ .
The Rise of Superstar Firms: Increased concentration and mark-ups are linked to the "winner-takes-most" principle, where a few highly productive firms dominate their respective sectors.

Oligopoly Models

Oligopoly Fundamentals: A market dominated by a few large suppliers where strategic interaction and interdependence are key. Firms can provide homogeneous or heterogeneous products.
Cartels and Collusion: Firms may coordinate to act as a monopoly to maximize joint profits.
- Example: OPEC: A group of oil-exporting countries that coordinate production levels to influence global prices. Historically, cooperation has fluctuated due to members' incentives to cheat on agreements to capture more profit.
Bertrand Competition (Price Competition):
- Firms set prices simultaneously and sell the demanded quantity.
- For homogeneous goods, the firm with the lowest price captures the entire market.
- Bertrand Paradox: Equilibrium occurs where all firms set $p = MC$ . Even with only two firms, the outcome can match perfect competition (zero economic profit).
- Friction Factors: Prices often stay above $MC$ due to product differentiation, switching costs (e.g., loyalty cards), search costs, and capacity constraints.
Cournot Competition (Quantity Competition):
- Firms simultaneously choose the quantity to produce.
- Reaction Function: The optimal quantity for one firm as a function of the quantity chosen by competitors.
- Quantitative Duopoly Equilibrium:
  - Inverse Demand: $p = 6 - 0.01(q_A + q_B)$ , and $MC = 2$ .
  - Firm A's Reaction Function: $q_A = 200 - 0.5q_B$ .
  - Firm B's Reaction Function: $q_B = 200 - 0.5q_A$ .
  - Nash Equilibrium: Solving the system yields $q_A = 133.33$ and $q_B = 133.33$ . Total $Q = 266.66$ . Price $p = 3.34$ .
- Comparing Models: The Cournot price ( $3.34$ ) is lower than the monopoly price ( $4$ ) but higher than the Bertrand/Perfect Competition price ( $2$ ).

Monopolistic Competition and Market Structure Overview

Market Structure Classification: Based on the number of providers and product nature:
- Perfect Competition: Many providers, homogeneous products, free entry.
- Monopoly: One provider, unique product, no free entry.
- Oligopoly: Few providers, can be homogeneous or differentiated products, no free entry.
- Monopolistic Competition: Many providers, differentiated (heterogeneous) products, free entry.
Monopolistic Competition Dynamics:
- Short Run: Similar to a monopoly, firms face downward-sloping demand and can make economic profits or losses where $MR = MC$ .
- Long Run: Due to free entry and exit, newcomers enter if profits are made. This shifts individual demand curves inward and makes them more elastic. Equilibrium occurs where price equals average cost ( $p = AC$ ), resulting in zero economic profit.
Efficiency in Monopolistic Competition:
- Excess Capacity: Firms produce less than the quantity that minimizes average cost (minimum efficient scale).
- Mark-up: Price remains higher than marginal cost ( $p > MC$ ) due to product differentiation.
- Welfare Loss: While there is a deadweight loss, policymakers often tolerate it because enforcing marginal cost pricing would require complex subsidies and administrative costs to sustain numerous firms.