1. Market Power
Chapter 5

2. Market Power
Definition. Actions taken by entrepreneurs to increase profits are called economic rent seeking. All firms are seeking economic rents, which sometimes results in market power. Definition. A situation in which a firm or a few firms can affect the price received for their product, and new firms do not enter the industry is called market power.

3. Firms with Market Power
Examples:
Microsoft, Wal-Mart, Korean Chaebols
US Tobacco: four firms control 90% of total production
Compare: four firms in the furniture industry control only 30%
Pricing: firms with market power set a price above equilibrium level.
Definition. An industry with a single producer of a good that has no close substitutes is called a monopoly
Oligopoly. An industry with only a few producers of a good is called oligopoly.
Definition. An organized group of producers who manage their output and pricing as if they were a monopoly is called a cartel.

4. Market Power and Tradeoffs
Our analysis will show that firms with market power
Charge more compared to competitive equilibrium
Produce less compared to competitive equilibrium
Make the society lose economic benefits
Market power is necessary to produce technological innovations
Research and development is necessary for long-run growth
Research and development is not profitable if it is not granted monopoly rights
Governments stimulate R&D in order to ensure constant flow of innovations
Monopolies and oligopolies have strong incentives to innovate in order to keep their market power

5. Monopolistic versus Competitive Demand Curve
A monopolist’s demand curve is downward-sloping
Want to sell moredecrease the price
Want to increase the pricesell less
A competitive firm’s demand curve is flat
Every firm is a price-taker
Can sell any number of units at the market price

6. Marginal Revenue for a Monopolist
Definition. The change in total revenue associated with a one-unit change in the output sold by a producer is called marginal revenue.
Marginal revenue is always less than the price for a monopolist
Marginal revenue can grow negative
Why can the marginal revenue for a monopolist NOT equal to the price?

7. Can Marginal Revenue for a Monopolist Equal the Price?
Total revenue when price equals $9: A + B
Total revenue when price equals $8: A + C
Marginal revenue between P=$9 and P=$8: (A+C)-(A+B) = C – B
If marginal revenue is equal to the price, it should be equal to $9 = C + $1
This implies that the price stays at $9 even as quantity demanded increases to 2 units, which is inconsistent with the law of demand

8. The Marginal Principle
Definition. A principle according to which in order to maximize profits, the producer should choose the output that equates marginal revenue and marginal cost, is called marginal principle. Note. Marginal principle is a particular instance of the costs and benefits analysis. In this case marginal revenue is the benefit, and marginal cost is the cost. Definition. Costs associated with producing 1 more (marginal) unit are called marginal costs of producing that unit.

9. Monopolistic Profit Maximization
Monopolist keeps on producing while MR>MC, e.g. Q1
MC is constant here, but it normally increases with output
When MR=MC, profits are at their maximum, corresponding to Q2
At Q3, MR<MC, and it pays off to decrease output in order to increase profits

10. Competitive Markets
An industry operates in a competitive market if it has
Many buyers and sellers that cannot affect the market price
Easy entry of new producers entering in response to economic profits
Firms producing very similar products
Buyers and sellers having perfect information about market conditions

11. Competitive Market Properties
No single decision-maker has a decisive influence
Buyers and sellers have a lot of choice from whom to buy and to whom to sell
Political rent seeking is almost impossible
Definition. The attempt to gain economic advantage through government action is called political rent seeking.

12. Monopoly and Competition
In competition, marginal revenue is equal to the market price
Competitive output would be at Q4
Competitive price would be at P1
Monopolist
Produces less
Charges more

13. Monopolistic Inefficiency
Monopolistic output Q2 is inefficient because for the units Q2 to Q4 MR>MC, so they should be produced because it would be socially efficient
Monopolistic output is less than the efficient output
Definition. The output where marginal social benefit equals marginal social cost is called efficient output.

14. Monopolistic Inefficiency: a Caveat
“Monopolistic profits are greater than normal returns, which is why monopolies are harmful.”
Monopolistic profits are a redistribution of income away from the buyers and toward the monopolist, which is not a cost to the economy as a whole
The real cost of the monopoly is the social economic value of the units that are not produced by the monopoly
Can we measure the total cost of these units?

15. Monopolistic Deadweight Loss
Under monopoly, the society does not receive units Q2+1, Q2+2,...,Q4
The sum total of all the marginal net benefits associated with these units is equal to the area of the triangle NME
The area of this triangle is normally referred to as the deadweight loss to the monopolistic production

16. Pharmaceutical Monopolies: Harmful?
Like any monopoly, pharmaceutical firms create deadweight losses by producing less and charging a higher price compared to perfect competition
Developing a new drug is very costly, which is why a competitive price may be too low to justify the R&D costs
A monopolistic position may be the only motivating force behind R&D in the medical drugs area!

17. Market Power and Economic Inefficiency
Has the market power increased in recent years?
Why is the existing market power not eliminated by new competition?
Does dominating the industry allow exercising of market power by raising market price?

18. Trend in Market Power
Shepherd’s study of US economy, : market power has decreased for the following reasons:
Foreign competition
Europe and East Asia recovery from World War II
Decline in transportation costs
Reduction of international trade barriers: tariffs and quotas
2) Government deregulation
Fewer licenses (interstate trucking)
Airlines regulation gives more room to small carriers
3) Government policies on mergers and price fixing
4) Information revolution
Access to information on prices and market around the country
WWW
Pryor’s 2001 study: industrial concentration has been increasing since 1992

19. Why isn’t competition destroying existing market power?
Barriers to Entry
Why isn’t competition destroying existing market power?
Definition. Any condition that prevents new firms from entering an industry with the same cost conditions as existing firms is called barriers to entry.
Sources of barriers to entry
Natural monopolies: only one firm can profitably supply the market
Control of essential input: diamonds in South Africa, bauxites in aluminum industry
Product differentiation: product varieties capture consumers
Government: patenting, Postal Service, import tariffs, quotas, professional licensing (taxis, physicians)
Superior product: Wal-Mart, Microsoft,

20. Oligopolies and Market Power
Most market power in the US is associated with oligopolies, pure monopolies are rare
Oligopolistic producers can cooperate to act like a monopolist
Illegal within any country, but tacit collusion possible
Cannot be controlled on an international scale: OPEC cartel since 1970s

21. OPEC Cartel OPEC = Organization of Petroleum-Exporting Countries
Algeria
Angola
Ecuador
Gabon
Indonesia
Iran
Iraq
Kuwait
Libya
Nigeria
Qatar
Saudi Arabia
United Arab Emirates
Venezuela
Objective: reduce output and prevent entry of new oil exporters
Cooperation is essential, but there are strong incentives to deviate from the agreement
Enforcing an agreement is difficult since observing that someone cheats takes some time

22. OPEC Cartel and World Production of Oil

23. Duopoly: a Cartel of Two Firms
A duopoly is a cartel of two firms
A duopoly agrees to split output evenly between themselves with the total output equal to the monopolistic level
Suppose the price goes down
Demand decreased
A duopoly partner cheated
In case of cheating, another firm will
Retaliate by producing beyond its quota
The cheater is aware of retaliation so he probably won’t cheat in the first place

24. Cooperation Difficulties in a Cartel
Cooperation in a cartel becomes more difficult if
Number of firms in industry increases
Detecting a cheater is more difficult
The holdout problem: some firms may refuse to cooperate
Firms become less similar
Cost-efficient firms will want larger profit shares

25. OPEC: New Entry 11 member and 6-10 nonmember countries
Price surged from $3 to $30 per barrel during 1970s
New entry occurred
Given enough time, suppliers will adjust to change the shape of the supply curve!

26. OPEC: Demand Adjustments
Consumers’ response to a price hike in the short-run
Reduce pleasure driving
Reduce home heating in the winter
Reduce home cooling in the summer
Consumers’ response in the long-run
Buy more energy-efficient cars, furnaces, and air conditioners

27. What‘s the Final Outcome?

28. OPEC Cartel: Dissimilarity of Members
Large reserves / small population: long-term orientation
Small reserves / large population: short-termism
Saudi Arabia
Early 1980s: substantial reduction in output  other countries cheating
Mid-1980s: Retaliation, price below $10 a barrel
1998: output cuts, price up by 4%
2000: Russia (non-member) increasing production, prices down

29. Effects of Higher Oil Prices
Huge investments in petroleum-related sectors
Expanding oil production in non-member countries
Projects in non-member countries to expand production of drilling rigs
Refinery industry expansion
Increased use of: mass transit, hybrid cars, wind power
Increased investment in renewable energy

30. Do a Few Dominating Firms Have Market Power?
Not necessarily if there are internal tensions among cartel members due to
A large number of firms
More dissimilar members
Limited enforcement of an agreement
Adjustment of both demand and supply over time
Government may put pressure on informal cartels

31. Market Power and Technical Progress
Superior technology is conducive to
Economic growth
Market power
Knowledge development is associated with large up-front costs
Marginal costs associated with the production of knowledge-based products is often low
Whenever the up-front costs are large compared to the marginal costs, monopolistic profits are necessary to justify production

32. Government and Market Power
General principles to guide government policy toward market power:
Limit mergers of firms producing very similar products
Anti-trust laws
Mergers in the refinery sector resulted in more efficient firms
Grant patents to support basic research (encourage economic rent-seeking in the knowledge-producing sector)
Discourage political rent-seeking to preclude government from becoming a source of market power itself
License system and the asymmetric information problem