(Absolute Market Power)

8/14/2019 (Absolute Market Power)

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MONOPOLYMONOPOLY

(absolute Market power)



FEATURESFEATURES

Single firmSingle firm

Produces & sells a particular good or Produces & sells a particular good or

service for which there are no perfectservice for which there are no perfectsubstitutessubstitutes

New firms are prevented from enteringNew firms are prevented from enteringmarketmarket



MARKET POWERMARKET POWER

Ability of a firm to raise price without losing all itsAbility of a firm to raise price without losing all its

salessales

Gives firm ability to raise price above average costGives firm ability to raise price above average cost& earn economic profit (if demand & cost conditions& earn economic profit (if demand & cost conditions

permit)permit)



MEASUREMENT OF MARKET POWER (1)MEASUREMENT OF MARKET POWER (1)

Degree of market power inversely related to price

Degree of market power inversely related to price

elasticity of demand

elasticity of demand

The less elastic the firm’s demand, the greater The less elastic the firm’s demand, the greater

its degree of market power its degree of market power The fewer close substitutes for a firm’s product,The fewer close substitutes for a firm’s product,

the smaller the elasticity of demand (inthe smaller the elasticity of demand (in

absolute value) & the greater the firm’s marketabsolute value) & the greater the firm’s market

power power

When demand is perfectly elastic (demand isWhen demand is perfectly elastic (demand is

horizontal), the firm has no market power horizontal), the firm has no market power




Lerner index measures proportionate amount by whichLerner index measures proportionate amount by which

price exceeds marginal cost (note that P = MC in Perfectprice exceeds marginal cost (note that P = MC in Perfect

comptt):comptt):

P MC

P

−=Lerner index



MEASUREMENT OF MARKET POWERMEASUREMENT OF MARKET POWER

Lerner indexLerner index

Equals zero under perfect competitionEquals zero under perfect competition

Increases as market power increasesIncreases as market power increases

Also equalsAlso equals –1/E –1/E , which shows that the index, which shows that the index

(& market power), vary inversely with elasticity(& market power), vary inversely with elasticity

The lower the elasticity of demand (absoluteThe lower the elasticity of demand (absolute

value), the greater the index & the degree of value), the greater the index & the degree of market power market power




If consumers view two goods as substitutes, cross-If consumers view two goods as substitutes, cross-

price elasticity of demandprice elasticity of demand (E (E XY XY ) ) is positiveis positive

The higher the positive cross-price elasticity,The higher the positive cross-price elasticity,

the greater the substitutability between twothe greater the substitutability between twogoods, & the smaller the degree of marketgoods, & the smaller the degree of market

power for the two firmspower for the two firms



DETERMINANTS OF MARKET POWERDETERMINANTS OF MARKET POWER

Entry of new firms into a market erodes market power Entry of new firms into a market erodes market power of existing firms by increasing the number of of existing firms by increasing the number of substitutessubstitutes

A firm can possess a high degree of market power A firm can possess a high degree of market power

only whenonly when strong barriers to entry strong barriers to entry existexist Conditions that make it difficult for newConditions that make it difficult for new

firms to enter a market in which economicfirms to enter a market in which economicprofits are being earnedprofits are being earned



COMMON ENTRY BARRIERSCOMMON ENTRY BARRIERS

(I) Economies of scale(I) Economies of scale

When LAC declines over a wide range of When LAC declines over a wide range of

output relative to demand for the product,output relative to demand for the product,

there may not be room for another largethere may not be room for another largeproducer to enter marketproducer to enter market

(II) Barriers created by government(II) Barriers created by government

Licenses, exclusive franchises, patent rightsLicenses, exclusive franchises, patent rights



COMMON ENTRY BARRIERSCOMMON ENTRY BARRIERS

(III) Input barriers(III) Input barriers

One firm controls a crucial input in theOne firm controls a crucial input in the

production processproduction process

(IV) Brand loyalties(IV) Brand loyalties

Strong customer allegiance to existing firmsStrong customer allegiance to existing firms

may keep new firms from finding enoughmay keep new firms from finding enoughbuyers to make entry worthwhilebuyers to make entry worthwhile



DEMAND & MARGINAL REVENUE FOR ADEMAND & MARGINAL REVENUE FOR A

MONOPOLISTMONOPOLIST

Market demand curve is the firm’s demand curveMarket demand curve is the firm’s demand curve

Monopolist must lower price to sell additional unitsMonopolist must lower price to sell additional unitsof outputof output

WhenWhen MRMR is positive (negative), demand is elasticis positive (negative), demand is elastic(inelastic)(inelastic)

For linear demand,For linear demand, MRMR is also linear, has the sameis also linear, has the samevertical intercept as demand, & is twice as steepvertical intercept as demand, & is twice as steep





DEMAND & MARGINAL REVENUE FOR ADEMAND & MARGINAL REVENUE FOR A

MONOPOLISTMONOPOLIST



SHORT-RUN PROFIT MAXIMIZATION FORSHORT-RUN PROFIT MAXIMIZATION FOR

MONOPOLYMONOPOLY

Monopolist attains maximum profits by producing thatMonopolist attains maximum profits by producing that

level of O/P for which positive difference b/w TR & TC islevel of O/P for which positive difference b/w TR & TC is

greatestgreatest

Profit maximization occurs by producing quantity for Profit maximization occurs by producing quantity for

whichwhich MR = MC MR = MC




MONOPOLYMONOPOLY

If If P P >> ATC ATC , firm makes economic profit, firm makes economic profit

If If ATC ATC >> P P >> AVC AVC , firm incurs loss, but continues to, firm incurs loss, but continues to

produce in short runproduce in short run

If demand falls below AVC at every level of output, firmIf demand falls below AVC at every level of output, firmshuts down & loses only fixed costsshuts down & loses only fixed costs




MONOPOLYMONOPOLY



SHORT-RUN LOSS MINIMIZATION FORSHORT-RUN LOSS MINIMIZATION FOR

MONOPOLYMONOPOLY



LONG-RUN PROFIT MAXIMIZATION FORLONG-RUN PROFIT MAXIMIZATION FOR

MONOPOLYMONOPOLY

Monopolist maximizes profit by choosing to produceMonopolist maximizes profit by choosing to produceoutput whereoutput where MR = LMC MR = LMC , as long as, as long as P P ≥≥ LAC LAC

Will exit industry if Will exit industry if P P << LAC LAC

Monopolist will adjust plant size to the optimal levelMonopolist will adjust plant size to the optimal level

Optimal plant is where the short-run averageOptimal plant is where the short-run averagecost curve is tangent to the long-run averagecost curve is tangent to the long-run averagecost at the profit-maximizing output levelcost at the profit-maximizing output level



LONG-RUN PROFIT MAXIMIZATION FORLONG-RUN PROFIT MAXIMIZATION FOR

MONOPOLYMONOPOLY



EXERCISEEXERCISE

Suppose that the TC equation for a monopolist is givenSuppose that the TC equation for a monopolist is givenby:by:

TC = 500 + 20 QTC = 500 + 20 Q22

The demand equation be:The demand equation be:

P = 400 – 20 QP = 400 – 20 QWhat are the profit maximizing price & quantityWhat are the profit maximizing price & quantity



SolutionSolution

MR = MCMR = MC

Q = 5Q = 5

P = 300P = 300



SOCIAL COST OF MONOPOLY: ALLOCATIVESOCIAL COST OF MONOPOLY: ALLOCATIVE

INEFFICIENCY & INCOME REDISTRIBUTIONINEFFICIENCY & INCOME REDISTRIBUTION



EXCERCISEEXCERCISE

Petersen & Lewis Pg # 337Petersen & Lewis Pg # 337

Problem 9.8Problem 9.8

Problem 9.9Problem 9.9

(Absolute Market Power)

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