Ch16 Study Notes

Monopoly and Market Power

Introduction

  • P = MC Monopoly / Market Power

Firm Demand Curve

  • Definition:

    • The quantity (Q) a firm will sell if it changes its price (P).

    • Distinct from the market demand curve.

  • Market Demand Curve:

    • Total quantity consumers will purchase across all firms at a given price.

    • Combined quantity all firms will sell if they set the same price.

Concepts of Market Structures

Perfect Competition

  • Characteristics:

    • Many buyers, each small relative to the market.

    • Many firms, each small relative to the market.

    • Identical goods.

  • Consequences:

    • No market power; buyers and sellers are price takers.

    • No interesting pricing decisions.

Demand Curves: Firm vs. Market Level

  • In a perfectly competitive market:

    • Price Taker: Firms can sell as much as they want at the prevailing market price but nothing above it.

    • Individual (firm) demand is perfectly elastic.

  • Marginal Revenue (MR) for Competitive Firms:

    • MR = P (since price remains constant regardless of quantity sold).

Market Power

  • Definition:

    • The ability to charge higher prices without losing many sales to competitors.

    • Characterized by a downward-sloping firm demand curve.

Monopoly

  • Definition:

    • Only one seller exists in the market.

    • In this case, market demand curve equals firm demand curve.

  • Implications of Monopoly:

    • Do monopolists have competitors?

    • Depends on the market definition. For instance, YKK has no zipper competitors but zippers compete with button flies.

Oligopoly and Monopolistic Competition

  • Characteristics of Oligopoly:

    • A few large sellers, products may be similar or different.

    • Focus on strategic interactions between firms.

  • Characteristics of Monopolistic Competition:

    • Many sellers; products are differentiated (e.g., jeans).

    • Competition is based on price, quality, customer service, reputation, and location.

  • Market Power in Monopolistic Competition:

    • Customers vary in willingness to pay based on product attributes.

Effects of Pricing Decisions

  • No Market Power Scenario:

    • Raising price even slightly loses all customers (perfectly elastic demand).

    • Competitive landscape:

    • Perfect Competition: Many Firms, Same Product, No Market Power

    • Monopolistic Competition: Many Firms, Differentiated Product, Some Market Power

    • Oligopoly: Few Firms, Same or Differentiated Products, Some Market Power

    • Monopoly: One Firm, Unique Product, Maximum Market Power

Setting Prices to Maximize Profit

  • Trade-off Between Price and Quantity:

    • Higher price = higher profit per item sold.

    • Higher price = fewer items sold.

  • Firm Demand Curve:

    • Summarizes the quantity buyers demand as price changes.

  • How to Discover Firm's Demand Curve:

    • Experimenting with different prices and plotting the quantity sold at each price.

    • Utilizing methods like customer surveys and varying prices across locations.

Marginal Revenue Analysis

  • MR Definition:

    • Additional revenue from selling one more unit.

  • Components:

    • Output Effect: Revenue increases by the price of the additional item sold (P).

    • Discount Effect: To sell one more unit, price must be lowered for all units sold (Q × ↓P).

  • Profit Maximization Rules:

    • If MR > MC, increase quantity to raise profits.

    • If MR < MC, decrease quantity to raise profits.

    • Maximize profit at quantity where MR = MC.

Examples of Market Power

  • Example:

    • HIV drugs priced at $10,000 per year vs. marginal cost of $100.

    • Daraprim price increase from $1 to $750 with marginal cost of $1.

  • Prison Phone Calls:

    • Costing $20 for a 15-minute call due to exclusive contracts yielding market power.

    • Federal regulations on interstate calls but not on intrastate, causing higher local call prices.

Welfare Cost of Market Power

  • Competitive Market Equilibrium:

    • At P = MC, maximizes total surplus.

  • Market Power Equilibrium:

    • At P > MR = MC, leading to deadweight loss as the quantity produced is too low.

    • Deadweight Loss Visual:

    • Competitive equilibrium at quantity QC yields maximum total surplus, while market power equilibrium at QM creates a surplus deficit.

Policy Solutions for Market Power

Increasing Competition

  • Antitrust Laws:

    • Sherman Antitrust Act (1890) and Clayton Antitrust Act (1914) to prevent mergers and break up monopolies.

Regulation for Natural Monopolies

  • Examples:

    • Electricity services may be more efficient with a single provider.

  • Regulatory Challenges:

    • Setting monopolist prices requires balancing between maximizing total surplus and avoiding losses.

Comparing Perfect Competition with Market Power

  • **Similarities:

    • Both aim to maximize profits and operate under the rule MR = MC.

  • Differences:

    • Number of firms: Many vs. One

    • Price determination: P = MC vs. P > MC

    • Impact on economic welfare: Perfect competition produces a welfare-maximizing output, while market power does not.