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Market Power Chapter 5
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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.
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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.
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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
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Monopolistic versus Competitive Demand Curve
A monopolist’s demand curve is downward-sloping Want to sell moredecrease the price Want to increase the pricesell 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
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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?
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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
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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.
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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
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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
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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.
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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
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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.
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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?
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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
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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!
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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?
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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
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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,
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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
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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
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OPEC Cartel and World Production of Oil
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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
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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
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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!
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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
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What‘s the Final Outcome?
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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
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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
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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
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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
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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
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