Market Power, Market Structures & Externalities – Comprehensive Study Notes

Monopoly

• Roadmap topics covered: Monopoly, Profit maximization for a single-price monopolist, Cartels, Regulation of Natural Monopoly, Price discrimination, Measures of market concentration, Oligopoly, Monopolistic competition, Externalities

• Characteristics
  • Single seller – the firm is the industry
  • No close substitutes – products unique enough that cross-price elasticity is very low
  • Price maker – faces the market demand curve, chooses any point on it
  • Barriers to entry keep rivals from eroding economic profit

• Barriers to entry (definition: any obstacle preventing new firms from entering)
  • Economies of scale – ATC falls over the entire relevant range; if the minimum efficient scale exceeds market demand the industry is a natural monopoly
  – Graph presented: ATC declines from Q=0 to at least Q=200\text{ million units}
  • Control/ownership of essential resources (e.g., De Beers diamonds, Alcoa bauxite)
  • Legal barriers – patents, licences, franchises, government regulations
  • Network effects – value of the product rises with number of users (e.g., social networks, operating systems)

Natural Monopoly & Economies of Scale

• Definition: industry with sufficiently large economies of scale that one firm can supply entire market at lower cost than any combination of multiple firms

• Cost diagram: average total cost curve continuously downward sloping; intersection with market demand implies single-firm lowest possible price

• Policy issue: How to regulate price and output while preserving scale economies

Demand, Revenue & Marginal Revenue of a Single-Price Monopolist

• Faces market demand curve P(Q)

• Total revenue TR = P\times Q

• Average revenue AR = \frac{TR}{Q} = P – demand curve doubles as AR curve

• Marginal revenue MR = \frac{\Delta TR}{\Delta Q}
  • Lies below demand curve because price must be lowered on all units to sell an extra unit
  • For linear demand, MR has same intercept and twice the slope

• Table (sample): when Q increases from 20 to 30 units, TR rises from 160 to 210, so MR = 50/10 = 5 etc.

Profit Maximization for a Monopolist

• Rule: choose Q^* where MC = MR

• Determine price P^ from the demand curve at Q^

• Economic profit rectangle: height = P^* - ATC(Q^), width = Q^

• No unique supply curve because firm is not a price-taker; chooses a point on demand not a mapping from price to quantity

Monopoly vs Perfect Competition

• Perfect competition long-run equilibrium: P = MC = \min ATC

• Monopoly: P > MC (markup) and QM < Q{PC}

• Deadweight loss – area between demand and MC from QM to Q{PC}

• Diagram shows D, MC, MR, monopoly output QM, competitive output QC and DWL triangle

Dynamic Perspective – Joseph Schumpeter

• Quote: monopoly can be “the most powerful engine of progress” via incentives for innovation and long-run output expansion, despite short-run restriction

• Implication: short-run inefficiency may finance R&D for long-run gains (creative destruction)

Cartels

• Definition: organization of producers acting collectively to behave like a monopolist, maximising joint profit

• Effects: reduced industry output, higher price

• Internal problems:
  • Monitoring & enforcement of individual output quotas (temptation to cheat)
  • Entry barriers must be maintained; otherwise new firms undercut price

• Real-world examples: OPEC, lysine cartel case

Regulation of Natural Monopoly

• Dilemma: need low cost from single firm yet want competitive price

• Policies:
  • Marginal-cost pricing – efficient (P=MC) but firm incurs losses if P < ATC ⇒ requires subsidy
  • Two-part tariff – access fee + per-unit charge = MC; access fee recovers fixed cost
  • Average-cost pricing – set P = ATC → zero profit, but output below efficient level (DWL)
  • Rate-of-return regulation – allow target % return on invested capital; can create gold-plating incentives
  • Price-cap regulation – ceiling on inflation-adjusted price index; gives cost-cutting incentives

Price Discrimination

• Definition: selling same good at >1 price not justified by cost difference

• Necessary conditions:
  • Market power
  • Ability to identify different WTP or elasticities
  • Prevent resale (arbitrage)

• Forms:

  1. Among units (first-degree/perfect): charge each unit at max WTP; captures full CS → efficient but all surplus to firm

  2. Among market segments (third-degree): different groups get different prices (student discount signs; barber shop example 10–15% off with ID)
     – Profit-maximizing rule: set output in each segment where MC = MR_i
     – Higher price in segment with less elastic demand

  3. Hurdle pricing (second-degree): create obstacle (rebate, coupon, mail-in offer, versioning) so consumers self-select

• Consequences: may raise firm profit; total output may rise, potentially increasing total surplus; distribution between PS and CS ambiguous

Measures of Market Concentration

• Four-firm concentration ratio CR4 – % industry revenue from 4 largest firms; industry deemed competitive if CR4 < 60\%

• Herfindahl-Hirschman Index HHI = \sum s_i^2 (percentages squared) for up to 50 firms
  • HHI < 1500 competitive, 1500\le HHI \le 2500 moderately concentrated, >2500 highly concentrated

• Statistics Canada examples:
  • Cigarettes HHI = 4409 (high)
  • Bakeries HHI = 1534 (moderate)
  • Sporting goods HHI = 370 (competitive)

Oligopoly & Game Theory

• Oligopoly: few sellers, interdependent decisions; strategic behaviour

• Game theory analyses decisions; key concepts:
  • Payoff matrix
  • Nash equilibrium: each player’s strategy is best response to others; no unilateral deviation profitable
  • Dominant strategy: best regardless of rival’s action
  • Prisoner’s Dilemma: equilibrium may be jointly suboptimal

Duopoly Example

• Strategies: cooperate (each ½ monopoly output, high profit) vs compete (each ⅔ output, low profit)

• Nash equilibrium: both compete (dominant) ⇒ lower joint profit

• Illustrates “oligopolist’s dilemma”

Airline Price War Game

• Payoffs (profits in $ millions):
  • Both cut: 400,400
  • Neither cut: 600,600
  • One cuts: cutter 800, other 200

• Payoff matrix reveals Nash equilibrium: both cut (dominant strategy), even though joint profit higher if neither cuts

Public Policy toward Oligopoly & Monopoly

• Antitrust / competition law: prevent collusion, break up anti-competitive mergers, fine cartels; aim to move output/prices toward competitive optimum

• Controversies: balancing efficiency vs innovation, false positives, international competitiveness

Monopolistic Competition

• Pioneers: Edward Chamberlin, Joan Robinson

• Characteristics:
  • Many firms, each small market share (independent)
  • Free entry/exit
  • Product differentiation ⇒ downward-sloping but elastic demand

• Short run: set MR=MC; profit can be +, 0 or −

• Long run: entry/exit shifts each firm’s demand until economic profit = 0 and MR=MC=ATC at tangency point

• Compared with perfect competition:
  • Excess capacity (output below Q_{minATC})
  • Markup P>MC ⇒ allocative inefficiency and DWL

• Welfare nuances: product-variety externality (positive) vs business-stealing externality (negative); difficult for policy to improve outcome because firms already zero-profit

Advertising

• Perfect competition: little/no advertising (identical products)

• Monopoly: may advertise to shift demand or goodwill

• Monopolistic competition & oligopoly: heavy advertising for differentiation and strategic interaction

• Pros: informs consumers, fosters competition, signals quality

• Cons: manipulative, wasteful, raises cost & price

Externalities

• Market failures beyond monopoly: externalities, public goods, asymmetric information

• Externality: cost/benefit from action borne by non-decision makers
  • Negative: pollution
  • Positive: R&D spillovers, vaccinations

Paint Factory Pollution Example

• Private benefit = social benefit of paint

• Costs:
  • Private cost (borne by producer)
  • External cost (borne by river residents)
  • Social cost = private + external

• Valuation example: identical riverside homes rent $500 less on polluted river ⇒ external cost 500\times10 = 5000 per month

Marginal Costs

• MC = marginal private cost

• Marginal external cost

• MSC = MC +\text{marginal external cost}

• Inefficient unregulated market equilibrium at MC=MSB; efficient at MSC=MSB; DWL created

Remedies for Negative Externalities

1. Property rights (Coase)
   • If rights well-defined and transaction costs low → bargaining achieves efficiency regardless of initial ownership

2. Technology standards – mandate clean technology when rights hard to enforce

3. Market-based instruments
   • Pigovian tax: set \text{tax} =\text{marginal external cost} so MC+\text{tax}=MSC; generates revenue, achieves efficient output
   • Cap-and-trade: government sets quota (cap) on total pollution, issues tradable permits; permit price equates MSC and MSB; same efficiency as tax but quantity certain

Carbon Tax Discussion (British Columbia)

• BC carbon tax since 2008; GDP ↑ 19\% (2007–2016) while net GHG ↓ 3.7\%

• Policy accompanied by revenue recycling (redistribution)

• Challenges: measuring external cost, political acceptability

Global Externalities

• Climate change is global; requires international cooperation; modeled as global prisoner’s dilemma (free-rider problem)

Readings & Coverage

• Monopoly & price discrimination: Chapters 10.1–10.3, 12.2

• Oligopoly & concentration: 11.1, 11.3–11.4, 12.2–12.3

• Externalities: 16.3, 17, 18.3

Key Equations & Definitions (Quick Reference)

• TR = P \times Q

• AR = P

• MR = \frac{\Delta TR}{\Delta Q}

• Profit = (P - ATC)\times Q

• Markup = P - MC

• MSC = MC +\text{marginal external cost}

• HHI = \sum{i=1}^{n} si^2 where s_i = market share (%) of firm i