Market Power and Imperfect Competition Study Notes

Market Power: Definition, Causes, and the Case of Google

• Market Power Definition: A firm possesses market power as soon as it does not behave as a price taker. These firms are known as price setters, and they employ various pricing strategies to increase and maintain long-term profits.
• Legal vs. Illegal Dominance: Having a dominant market position is not punishable under law; however, the abuse of that position is. An example of this is Google, which holds a share of over $90\%$ in the online search engine market in the United States and Europe.
• Google Antitrust Case Studies:
  • Google Shopping (2017): Google was fined $\text{€}2.4\,\text{billion}$ by the European Commission for favoring its own product comparison service in search results. Higher rankings were given to Google Shopping over competitors like beslist.nl, causing a collapse in competitor traffic.
  • Android Operating System (2018): A fine of $\text{€}4.2\,\text{billion}$ was imposed for abusing dominance in the smartphone OS market. Google required manufacturers to pre-install Google Search and Chrome, sometimes paying them to make Google Search the default, and prohibited devices using non-Android coding standards.
  • AdSense (2019): Google was fined $\text{€}1.49\,\text{billion}$ for requiring websites using a Google search bar to only place ads through its online advertising service, specifically targeting market share from Yahoo and Microsoft.
• The Persistence of Profits: For a firm to maintain economic profits in the long run, there must be barriers to entry that prevent or discourage new firms from entering the market. These are categorized into technological, regulatory (legal), and strategic barriers.

Technological Barriers to Entry

• Economies of Scale: This occurs when average costs fall as the quantity of output increases.
• Natural Monopoly: A natural monopoly arises when one firm can provide a good or service at a lower total cost than two or more firms. This is common in utilities like drinking water, gas, and electricity due to very high fixed costs associated with delivery networks. In these markets, it is inefficient to have competing infrastructures (e.g., two parallel high-voltage networks).
• Cost Efficiency in Scale: As shown in mathematical models, if two firms each produce a quantity $q^\star$, the total cost is twice the striped area on a cost curve. However, one firm producing $2q^\star$ reaches a lower average cost because the orange area on the cost graph is smaller than the combined costs of two separate firms.
• Network Effects: These occur when the value of a product increases as more people use it.
  • Direct Network Effects: The service becomes more valuable as the number of users grows (e.g., a telephone is useless if you are the only owner, but increases in value as friends join the network).
  • Indirect Network Effects: These occur in platforms that connect two types of users. For example, media products bring users and advertisers together; game consoles bring gamers and developers together. A developer only releases games for a console with enough users, and users only buy consoles with enough games.
• Exclusive Ownership of Inputs: Owning essential raw materials creates market power. For example, an aluminum producer could become a monopolist by owning all global bauxite reserves.
• Unique Technological Know-how: Possessing non-imitable knowledge or secret production processes (e.g., the formula for Coca-Cola or the complexity of building nuclear power plants) acts as a significant barrier.

Legal and Strategic Barriers to Entry

• Government Imposed Restrictions: Governments may create legal barriers through competition bans (e.g., passenger transport via NMBS in Belgium) or by issuing limited licenses (e.g., pharmacy per-neighborhood limits or radio transmission frequencies).
• Exit Barriers: High termination fees or legal regulations on exiting a market can deter entry. If a firm is unsure of its survival, the risk of high exit costs makes entering the competition unattractive.
• Patents: These are granted to encourage research and development (R&D). They provide temporary monopolies, protecting inventors from imitation for a set period (typically $20\,\text{years}$). This allows for monopoly profits to recoup R&D investments. Examples include Xerox copiers and the pharmaceutical industry.
• Strategic Behavior: Firms may intentionally make entry expensive for rivals:
  • Lawsuit Threats: Monopolists may threaten expensive legal action against rivals claiming patent infringement.
  • Quality Reputation: Heavy advertising creates a perception of high quality, making new, unbranded products seem unreliable.
  • Aggressive Marketing: Forcing new entrants to match big advertising budgets or give away free products to gain market share can make entry financially unviable.
• Credibility of Threats: For strategic barriers to work, threats must be credible. A threat to sue is ignored if the monopolist clearly lacks legal standing, as the legal costs and risk of losing would deter the monopolist from following through.

Monopoly Output and Efficiency

• Monopoly Characteristics: A single supplier serving the entire market with a product that has no good substitutes, putting the firm in a position of economic dominance.
• Output Rule: A profit-maximizing monopolist chooses the output level where marginal cost ($MC$) equals marginal revenue ($MR$).
• Mathematical Model of a Sandwich Monopolist:
  • Inverse demand function: $p(q) = 6 - 0.01q$
  • Total revenue: $TR(q) = 6q - 0.01q^2$
  • Marginal revenue: $MR(q) = 6 - 0.02q$
  • At the profit-maximizing point $M$, where $p_M = 4$ and $AC = 2$, the profit is the positive difference between price and average cost.
• Monopoly vs. Perfect Competition:
  • No Supply Curve: The monopolist, as a price setter, does not have a supply curve; they only occupy a single preferred point on the demand curve.
  • Elastic Demand: The monopolist always operates on the elastic part of the demand curve where marginal revenue is positive ($MR > 0$).
  • Price and Marginal Cost: The monopoly price is always higher than the marginal cost ($p > MC$). The gap between them increases as demand becomes less elastic (e.g., life-saving medicines have low price sensitivity, allowing high mark-ups).
• Deadweight Loss (DWL): Monopoly results in an efficiency loss because the quantity offered is smaller than in perfect competition. Some consumers with a willingness to pay higher than the $MC$ are not served because the monopolist would have to lower prices for all consumers to serve them, reducing overall profit.
• Rent-Seeking: Monopolists may spend their profits to influence policymakers to protect their position. This use of resources for non-productive purposes is considered an additional efficiency loss.
• Static vs. Dynamic Efficiency: While monopolies cause static efficiency losses (DWL), they may provide dynamic efficiency gains. Patents provide the profit incentive necessary for high-cost innovation, which benefits society in the long run.

Price Discrimination Strategies

• Definition: The strategy of charging different prices to different consumers for the same product to increase profit.
• Perfect Price Discrimination (1st Degree): The firm charges every consumer their maximum willingness to pay. The marginal revenue curve then coincides with the demand curve. The quantity produced equals the competitive equilibrium ($q_M = 400$), but the consumer surplus is entirely captured as producer profit. This is rare because willingness to pay is usually unknown.
• Market Segmentation (3rd Degree): Dividing the market into groups based on observable characteristics.
  • Example: A cinema charging lower prices for youngsters than adults. Profit is maximized when the $MR$ in the youth submarket equals the $MR$ in the adult submarket, both equaling $MC$. Prices are higher in the more inelastic segment (adults).
  • Condition: Resale must be impossible; transaction costs like transport or duties often help maintain these segments.
• Self-Selection (2nd Degree): The firm offers different versions of a product, and consumers choose based on their preferences.
  • Example: Airline tickets. Business travelers are less price-sensitive and value flexibility. By charging more for flexible tickets and less for restricted ones, the airline segments the market without knowing user identities. For this to work, the "loss of quality" in the cheaper version must be more painful for the high-willingness-to-pay group.
  • Intertemporal Price Discrimination: Charging different prices over time. "Skimming prices" involve high initial prices for the fashion-conscious or risk-averse, followed by lower sale prices for more patient consumers.

Market Power and Concentration Data

• Mark-up Analysis: The ratio of price over marginal cost ($p/MC$). In perfect competition, mark-up is $1$.
• Global Trends: Calculations by Jan De Loecker and Jan Eeckhout for over $70,000$ firms in $134$ countries show mark-ups rose from $1.0-1.2$ in the 1980s to being $60\%$ to $100\%$ higher than marginal cost today. This is largely driven by large, high-mark-up firms.
• Concentration Index ($C_4$): Measures the market share of the four largest firms in an industry. The higher the $C_4$, the higher the concentration. In the US retail sector (supermarkets), the $C_4$ has doubled in the last $30\,\text{years}$.
• Superstar Firms: Authors like Autor et al. (2020) argue that industries with the highest productivity gains concentrate around "superstar firms" that dwarf competition. Conversely, others argue concentration stems from anti-competitive lobbying and mergers.

Oligopoly Models

• Oligopoly Definition: A market structure with a few firms characterized by strategic interaction, where one firm's decisions impact another's profits. This lies between the extremes of perfect competition and monopoly.
• Bertrand Competition: Firms compete on price.
  • If products are homogeneous, the firm with the lowest price captures the whole market.
  • Bertrand Paradox: Even with only two firms, competition drives prices down to marginal cost ($p = MC$), resulting in zero economic profit.
  • Factors avoiding the Paradox: Switching costs (e.g., loyalty cards, phone number portability), search costs (difficulty in comparing prices), and capacity constraints.
• Cournot Competition: Firms compete on quantity/capacity.
  • Firms decide production volume simultaneously, and a market price emerges to clear the supply.
  • Reaction Curve: A function showing a firm's optimal quantity given the competitor's quantity.
  • Cournot-Nash Equilibrium: The point where reaction curves intersect. For a duopoly with $p(q) = 6 - 0.01(q_A + q_B)$ and $MC = 2$, the equilibrium occurs at approximately $133\,\text{units}$ per firm. The resulting price ($\text{€}3.34$) exceeds marginal cost, allowing for positive profits.
• Product Differentiation:
  • Vertical: Difference in quality (e.g., BMW vs. Dacia Duster).
  • Horizontal: Difference in subjective valuation (e.g., preference for BMW vs. Jeep).
  • Perception: Even identical products (e.g., Paracetamol) can be differentiated via branding. Dafalgan sold for $\text{€}6.99$ ($\text{€}0.22/\text{pill}$) compared to Paracetamol Teva at $\text{€}4.99$ ($\text{€}0.17/\text{pill}$).
  • Differentiation allows firms to avoid intense price competition, leading to higher market power.

Overview of Market Structures

• Perfect Competition: Many providers, homogeneous products, free entry/exit, price takers, zero economic profit.
• Monopoly: One provider, no substitutes, no free entry, price setter, positive economic profit.
• Monopolistic Competition: Proposed by Joan Robinson and Edward Chamberlin in 1933. Characterized by many providers and differentiated products. Firms have market power in the short run (price setters), but free entry/exit leads to zero economic profit in the long run. Example: The hospitality industry (bars/restaurants).
• Oligopoly (Bertrand/Cournot): Some providers, can have homogeneous or differentiated products, strategic interaction dominates behavior.