Chapter 14 – Market Structure, Market Power, and Public Policy

Market Structure and Your Business Strategy

• Market structure = competitive environment in which your firm operates.
  • Shapes your pricing & output decisions.
  • Strategy must answer:
  • How many rivals? (lots / few / none)
  • Will new entrants arrive?
  • Are products identical or differentiated (quality, service, brand, location)?
• Key managerial question: “Tailor my strategy to my market structure.”

Key Definitions: Market Power & Market Structures

• Market power: Ability to charge a higher price without losing many sales.
  • Gas-station examples illustrate extremes:
  • Only station in town ⇒ high power (few drive elsewhere).
  • One of four at an intersection ⇒ virtually none.
• Perfect competition
  • Conditions: many buyers/sellers, identical product.
  • Result: Zero market power, you are a price-taker.
  • Example: farmers at a vegetable market.
• Monopoly
  • Only one seller, unique product ⇒ max market power.
  • Example: De Beers (held >85 % of world diamonds); still faces substitution to rubies, emeralds.
• Monopolistic competition
  • Many small sellers, differentiated products via taste, brand, quality, location, service, etc.
  • More distinct product ⇒ greater market power.
  • Apples (Red Delicious, Fuji, Honey Crisp) or jeans (Levi’s vs Target).
• Oligopoly
  • Only a handful of large sellers; products may be similar or differentiated.
  • Significant power, but rivals’ reactions matter ⇒ strategic interaction.
  • Example: U.S. cell service shares—AT&T 45 %, Verizon 29 %, T-Mobile 25 %.
• Imperfect competition
  • Catch-all for markets where firms face some power (monopolistic competition + oligopoly).

Spectrum of Market Power

• Perfect competition ⇢ least power; flat firm demand.
• Imperfect competition (mono. comp & oligopoly) ⇢ some power; downward-sloping firm demand (steeper = more power).
• Monopoly ⇢ most power; firm demand = market demand (steep & inelastic).
• Sources of market power:
  • Few competitors.
  • Differentiated / unique product.

Five Key Insights into Imperfect Competition

• More competitors → less power (entry barriers matter).
• With power, you can set independent pricing strategies, yet still obey the law of demand.
• Successful product differentiation boosts power.
• Imperfect competition among buyers gives them bargaining power (large, scarce customers negotiate lower prices).
• Interdependence: Your best move depends on rivals’ moves (pricing, positioning, entry).

Setting Prices When You Have Market Power

• Central trade-off:
  • Lower price ⇒ higher quantity but lower margin.
  • Higher price ⇒ bigger margin but fewer sales.
• Two analytic tools:
  • Firm demand curve – how buyers of your firm respond to your price.
  • Marginal revenue (MR) curve – extra revenue from one more unit.

Firm Demand Curve

• Differs from:
  • Market demand (all firms) – identical only for a monopoly.
  • Individual buyer’s demand.
• Shapes:
  • Perfect competition ⇒ nearly horizontal (highly elastic).
  • Monopoly ⇒ steep; identical to market demand.
  • Greater power ⇒ steeper (more inelastic).
• 90 % of major retailers run pricing experiments (A/B tests across customer segments, locations, times) to map their own demand.

Marginal Revenue (MR)

• Define: \text{MR}=\Delta(TR)/\Delta Q where TR = P \times Q.
• Two forces:
  • Output effect: Gain P from selling the extra unit.
  • Discount effect: Lose \Delta P \times Q because price cut applies to all previous units.
  • \text{MR}=\text{Output effect} - \text{Discount effect}.
• Example – cars priced between 24{,}000 and 21{,}000:
  • Table (Price, Quantity, TR, MR):
  • (1) 24{,}000 → TR=24{,}000 → MR=24{,}000
  • (2) 23{,}000 → TR=46{,}000 → MR=22{,}000
  • (3) 22{,}000 → TR=66{,}000 → MR=20{,}000 (output +$22 k, discount –$2 k)
  • (4) 21{,}000 → TR=84{,}000 → MR=18{,}000
• Graph: MR curve lies below demand curve and declines faster (discount effect grows with Q).

The Rational Rule for Sellers

1. Choose quantity where MR = MC (marginal cost).
2. Set price on the demand curve at that quantity (highest price buyers are willing to pay).
   • Never price off the MR curve.

• Numerical car example (constant MC=20{,}000):
  • MR=MC at Q = 3; price from demand = 22{,}000.
  • Profit = TR - TC = 66{,}000 - 60{,}000 = 6{,}000 (max).

The Problem with Market Power

• Higher prices: Firms price above MC (AIDS drug 10{,}000/yr vs MC < 1).
• Underproduction: Quantity chosen is below efficient level; MC < MB for extra units ⇒ deadweight loss.
• Larger economic profits: Firms forego competitive outcome because power yields bigger margins.
• Cost inefficiency tolerated: Without competitive pressure, high-cost firms can survive.

Graphical Comparison

• Demand, MR & MC curves:
  • Competitive outcome: P=MC, larger Q.
  • Market-power outcome: higher P, smaller Q, positive profit rectangle.

Public Policy to Restrain Market Power

Fundamental Tension

• Society benefits from competition; incumbent firms gain from restricting it.
• Government role: maintain competition + limit harmful exploitation.

Policies to Ensure Competition Thrives (Competition / Antitrust Policy)

• Anti-collusion laws: Ban agreements to restrict price/quantity/quality or divide markets.
• Merger laws: Block mergers that "substantially lessen competition" (e.g., AT&T–T-Mobile 2011; Staples–Office Depot 1997). Allow if cost savings pass to consumers.
• Illegal to attempt to monopolize: Outlaw predatory pricing, exclusionary contracts (e.g., “Me-or-them” supplier demands).
• Encouraging international trade: Imports erode domestic firms’ power.

Policies to Minimize Harm When Power Is Inevitable

• Price ceilings: Cap monopoly price, eliminate incentive to restrict output.
• Regulation of natural monopolies
  • Natural monopoly = declining MC over relevant range ⇒ one firm cheapest (e.g., water, gas, electricity).
  • Government may impose rate-of-return caps, marginal-cost pricing with subsidies, or public ownership.

Key Take-Aways (Entire Chapter)

• Market structure dictates market power:
  • Perfect competition = none, monopolistic competition/oligopoly = some, monopoly = most.
• Market power stems from few rivals + product differentiation.
• With power:
  • Set MR=MC for quantity, price off demand.
  • Outcome → higher price, lower quantity, greater profits, potential inefficiency.
• Public policy combats these issues via competition promotion & targeted regulation.