Microeconmics

Microeconomics • Market Power Study Notes Page 1
MICROECONOMICS STUDY NOTES
Market Power • Elasticity • Surplus • Deadweight Loss • Monopoly • Mergers
1. Class Announcements
• Problem set is due Friday; an extra-credit problem set is also available.
• For the paper presentation, form groups of ideally five and submit group members’ names and emails by Friday. The
professor may combine smaller groups.
• Pick up the exam at the end of class.
2. Market Power and Price Elasticity
Market power is a firm’s ability to influence the price it charges rather than simply accepting a market price.
• Many close substitutes → demand is more elastic → buyers can switch easily → smaller markup and less pricing power.
• Few close substitutes → demand is less elastic → buyers have fewer alternatives → larger markup and more pricing
power.
The lecture’s markup relationship:
(P − MC) / P = 1 / |ε|
P = price; MC = marginal cost; |ε| = the absolute value of price elasticity of demand. Demand elasticity is usually negative,
so the formula uses its absolute value.
• Marginal cost (MC): the additional cost of producing one more unit.
• Markup per unit: price minus marginal cost, or P − MC.
Rearranged to solve for price:
P = MC / (1 − 1 / |ε|)
3. Consumer, Producer, and Total Surplus
Consumer surplus (CS)
The difference between what a buyer is willing to pay and what the buyer actually pays. On a standard graph, it is the area
below the demand curve and above the market price.
Producer surplus (PS)
In the simplified model used in the lecture, the difference between the price received and marginal cost, summed over units
sold. On a graph, it is the area above marginal cost and below price.
Important: Producer surplus is not always the same as accounting or economic profit when fixed costs are present.
Total surplus (TS)
Total surplus = consumer surplus + producer surplus. It represents the gains from trade shared by buyers and sellers.
Worked example from the lecture
• Price = $27,500; marginal cost = $15,000; quantity sold = 30; maximum willingness to pay = $40,000.
• Producer surplus: ($27,500 − $15,000) × 30 = $375,000.
• Consumer surplus (triangle): ½ × 30 × ($40,000 − $27,500) = $187,500.
• Total surplus: $375,000 + $187,500 = $562,500.

Microeconomics • Market Power Study Notes Page 2
4. Deadweight Loss and Market Exclusion
Deadweight loss (DWL) is total surplus lost when trades that would benefit buyers and sellers do not happen.
• A monopoly may set price above marginal cost. Buyers whose willingness to pay is above MC but below the monopoly
price may decide not to buy.
• Those missing transactions would have created gains from trade, so their absence creates deadweight loss.
• A transfer of surplus from consumers to the producer is not, by itself, deadweight loss. The loss comes from beneficial
transactions that no longer occur.
Remember: A higher price can transfer surplus from buyers to sellers; fewer mutually beneficial sales create deadweight
loss.
5. Benefits and Costs of Market Power
Possible benefit
Market power can sometimes encourage innovation. If a firm expects returns from a new product, it may be more willing to
invest in research and development or cover large upfront costs.
Possible costs
Market power can also lead to high prices, reduced output, fewer choices, and consumers being priced out. The lecture
used high insulin prices as an example of a potential harm.
6. Monopoly and Natural Monopoly
• Monopoly: a market with one seller and no close substitutes.
• Natural monopoly: one provider can supply the market at lower cost than multiple competing providers, often because
infrastructure costs are extremely high.
• Examples discussed included water, electricity, and rail networks.
• Governments may regulate a natural monopoly’s prices or service because duplicating infrastructure can be wasteful and
a single provider may otherwise have substantial pricing power.
7. How Firms Protect or Build Market Power
• Patents: temporary legal protection for an invention can help firms recover research and development costs, while also
limiting competition.
• Advertising and branding: can make products seem less interchangeable, reducing how readily customers switch to
competitors.
• Lobbying and political influence: can shape rules in ways that protect a firm from competition.
• Cartels: competing firms may coordinate to restrict output or raise prices. Coercive or illegal cartel behavior can harm
consumers and undermine competition.
8. Mergers: More Market Power or Lower Costs?
A merger combines two firms. It can reduce competition and make demand less elastic for the combined firm, allowing a
higher markup. But a merger may also create cost savings, lowering marginal cost.
The key question is whether cost savings are large enough to offset harm from reduced competition. The answer depends
on evidence and the specific market.

Microeconomics • Market Power Study Notes Page 3
Three hypothetical examples using the markup formula
Scenario MC |ε| Calculation Price
1. Before merger $20 3 (P − 20)/P = 1/3 $30
2. After merger, no
cost savings
$20 2 (P − 20)/P = 1/2 $40
3. After merger, with
cost savings
$10 2 (P − 10)/P = 1/2 $20
These are hypothetical calculations used to illustrate the formula, not actual prices or outcomes from the T-Mobile/Sprint merger.
9. Formula Practice: Solving for Price
Example 1: MC = $20 and |ε| = 3.
• (P − 20)/P = 1/3 → 1 − 20/P = 1/3 → 20/P = 2/3 → P = $30.
Example 2: MC = $20 and |ε| = 2.
• (P − 20)/P = 1/2 → 1 − 20/P = 1/2 → 20/P = 1/2 → P = $40.
Example 3: MC = $10 and |ε| = 2.
• (P − 10)/P = 1/2 → 1 − 10/P = 1/2 → 10/P = 1/2 → P = $20.
10. Key Takeaways
• More elastic demand → smaller markup; less elastic demand → larger markup.
• Markup formula: (P − MC)/P = 1/|ε|.
• Consumer surplus is buyer benefit; producer surplus is seller benefit above marginal cost in the simplified model.
• Total surplus = CS + PS.
• Deadweight loss comes from mutually beneficial trades that do not happen.
• Market power can sometimes reward innovation, but it can also raise prices and restrict output.
• A merger can increase pricing power and/or reduce costs; assess both effects