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Study Notes on Firms with Market Power - Chapter 5

Chapter 5: Firms with Market Power

Core Ideas

  • Firms attempt to maximize profits.
  • Firms possessing market power produce less than what would maximize gains from trade.
  • Governments may intervene in markets where firms have market power.

Outline

  1. Introduction
  2. Demand, Costs, and the Choice of Price and Quantity
  3. Demand Elasticity and the Firm’s Marginal Revenue
  4. Properties of the Profit Maximizing Quantity
  5. Gains from Trade
  6. Interdependency Between Firms
  7. Public Policy Towards Firms with Market Power

1. Introduction

  • Firms differ in strategies to achieve success (differentiation).
  • Successful firms identify unique product characteristics that attract customers.
  • Innovation, product development, marketing, production, and distribution efficiency are crucial for maintaining a market position.

2. Demand, Costs, and the Choice of Price and Quantity

The Demand Curve

  • The demand curve indicates the number of good units buyers wish to purchase at any price level.
  • It generally slopes downwards (law of demand): as price increases, quantity demanded decreases.

Willingness to Pay (WTP)

  • WTP measures how much a consumer values a good, represented by the maximum price they would pay for a unit.
  • For example, a consumer may pay up to $7 for the first pound of Cheerios.

Price and Quantity Choices

  • With the demand curve available, firms can select any (P, Q) combination.
  • The optimal point of choice is contingent on the firm’s objective (e.g., profit maximization).

Profit Maximization

  • Assumption: firms aim to maximize profit.
  • Cost: Total cost comprises the sum of all costs incurred to produce a good.
  • Revenue: Total revenue is calculated as the number of units sold multiplied by the price per unit.
  • Profit Formula: [ ext{Profit} = ext{Revenue} - ext{Total Cost} ]

Economic Versus Accounting Profit

  • Accounting Profit: Includes direct payments like wages, energy, rent, etc.
  • Economic Profit: Encompasses opportunity costs. For instance, if an individual forgoes a 100,000 EUR job to start a business, that amount is subtracted from economic profit.
  • Generally, ( ext{Economic Profit} < ext{Accounting Profit} )

Example of Profit Calculation

  • For breakfast cereal costing $2 to produce:
    • Profit for sold quantity Q at price P requires calculations based on production cost and revenue.

Isoprofit Curves

  • Isoprofit curves determine all price and quantity combinations yielding the same profit.
  • General equation: [ ext{Profit} = (P - 2) imes Q ]
  • Example pairs: Profit of 100 can be achieved with combinations of ((4, 50) ext{; }(6, 25) ext{; }(7, 20)).

Optimal Choice

  • The profit-maximizing quantity occurs where the isoprofit curve is tangent to the demand curve.
  • Graphical representation of demand curves and isoprofit curves indicates feasible pricing strategies.

Different Costs

  • Variable Costs: Change with production volume.
  • Fixed Costs: Remain constant irrespective of production.
  • Total Cost: Combined fixed and variable costs.
  • Average Cost: ( ext{Total Cost} / ext{Units Produced} )
  • Marginal Cost: Incremental cost of producing one additional unit.

Example: Beautiful Cars Company

  • Production cost function: ( C(Q) = 80,000 + 14,400 imes Q )
    • Fixed Cost: 80,000
    • Variable Cost: ( 14,400 imes Q )
    • Marginal Cost: 14,400
    • Average Cost: ( 80,000/Q + 14,400 )

Big Firms’ Cost Advantages

  • Larger firms may achieve lower costs due to:
    • Economies of scale: Average costs decrease with higher production output.
    • Technological advancements that lead to efficient production.

Economies of Scale

  • Average cost declines as production volume increases—resulting in either financial or technical benefits from large-scale operations.

3. Demand Elasticity and the Firm's Marginal Revenue

Elasticity of Demand

  • Price elasticity measures consumer responsiveness to price changes. Examples include:
    • 1% price increase leading to a 5% decrease in quantity demanded indicates elasticity = 5.
    • A 10% price decrease causing a 20% increase in quantity demanded indicates elasticity = 2.

Interpretation of Demand Elasticity

  • Elasticity greater than 1: Demand decreases more than 1% when prices increase by 1% (elastic demand).
  • Elasticity less than 1: Demand changes less than 1% when prices rise (inelastic demand).
  • The slope of the demand curve helps assess elasticity; more vertical suggests inelasticity.

Perfectly Elastic Demand

  • Defined as elasticity equal to infinity; consumers will buy at one price, but demand fundamentally shifts with any price change.

Demand Elasticity and Market Power

  • Firms with downward-sloping demand curves possess market power, allowing them to set prices without losing all customers.
  • Higher elasticity indicates less market power; monopolies experience the least elasticity.

Causes of Market Power

  • Supported by product differentiation and economies of scale.
  • Firms innovatively position themselves as unique to decrease elasticity via branding.

Revenue Effects of Demand Elasticity

  • Revenue dynamics depend on the interplay between quantity sold (quantity effect) and price per unit (price effect).
  • Elastic demand yields increased total revenue with price reductions, while inelastic demand results in decreased total revenue.

4. Properties of the Profit Maximizing Quantity

Profit Maximizing Quantity

  • The point at which the isoprofit curve is tangent to the demand curve exemplifies profit-maximizing behavior. For instance, selling prices and quantities are strategically determined as depicted in graphs.

Property 1: Price Markup

  • Defined as: [ rac{(P - MC)}{P} ]
  • At profit-maximizing quantity, price markup correlates with demand elasticity:
    [ rac{- MC}{P} = rac{1}{ ext{Elasticity}} ]

Explanations for Property 1

  • Reflects how less competition leads to lower demand elasticity, causing firms to raise their price markups.

Property 2: Marginal Revenue Equals Marginal Cost

  • Within the profit-maximizing quantity framework:
    • If marginal revenue (MR) exceeds marginal cost (MC), the firm should increase output.
    • Conversely, if MR is less than MC, reducing output is profitable.
  • The equilibrium point is where ( MR = MC ).

5. Gains from Trade

Measuring Gains from Trade

  • Consumer Surplus: Represents benefits consumers receive by paying less than their maximum WTP.
  • Producer Surplus: Difference between selling price per unit and the marginal cost of production.
  • Total Surplus: Combines consumer and producer surplus, representing overall gains from trade.

Example of Gains from Trade

  • Illustrated with Beautiful Cars selling 32 cars at $27,200:
    • Consumer with WTP $34,000 receives a surplus of $6,800.
    • Consumer with WTP $30,400 has a surplus of $3,200.
    • Producer surplus calculated as ( (27,200 - 14,400) \times 32 = 409,600 ).

Caveats in the Gains from Trade Measure

  • Producer surplus doesn't account for fixed costs leading to discrepancies in perceived economic benefit.
  • Adding consumer surplus can misrepresent overall welfare due to individual differences in preference.

Deadweight Loss

  • The profit-maximizing quantity results in a total surplus reduction, manifesting as a deadweight loss (DWL) illustrated graphically.

6. Interdependency Between Firms

Forms of Market Power

  • Monopoly: One firm with no close substitutes.
  • Monopolistic Competition: Multiple firms selling differentiated products.
  • Oligopoly: Few firms whose decisions impact each other significantly.

Strategic Interaction in Oligopolies

  • Decisions in an oligopoly influence competitors significantly.
  • Examples include price adjustments affecting overall profitability within the market.

Surfing Example: Strategic Pricing

  • Different pricing strategies analyzed (high vs. low price) based on consumer segments—loyal, price-sensitive, and price-driven.
  • Marketing outcomes illustrate strategic interdependencies leading to Nash equilibria outcomes based on consumer behavior.

Impact of Demand Elasticity

  • Pricing strategies related to consumer loyalty impact the overall market competitiveness and profitability as firms evaluate elasticity dynamics.

7. Public Policies Towards Firms with Market Power

Competition Policy

  • Addresses market power to rectify Pareto inefficiencies and deadweight losses.
  • Regulations in Europe (competition policy) and the US (antitrust laws) aim to foster competitive markets.

Regulation by Competition Authorities

  • Essential in monitoring firm behavior that limits competition through either overt or covert methods (e.g., mergers, collusion).

Policy Maker Interventions

  • Address imbalances by regulating monopolies, encouraging competition or solely evaluating implications before acting.

Regulation versus Public Ownership

  • Governments may regulate behaviors or take over monopolies in essential service sectors.

Passive Policy Versus Active Intervention

  • Many firms possess inherent market power; thus, competition authorities focus on industries with significant economics.

Challenges in Evaluating Market Power

  • Competition authorities face dilemmas in assessing firms with characteristics of natural monopolies versus competitive pressures.

Summary

  • Firms differentiate products through innovation and advertising, gaining market power.
  • Market power can arise from economies of scale, elevating prices above marginal costs contributing to deadweight loss.
  • Policymakers work to mitigate market distortions resulting from market power across industries.