Firms with Market Power

1. Firms with Market Power • Essentially firms with market power(aka.monopoly power) include all firms that are not price-takers or are not confronted with a perfectly elastic demand curve. • Thus, market power means that the firm has some control over price. It can raise price without losing all of its sales. • Thus, this chapter includes firms with significant price control and firms with some but little price control.

2. (Pure) Monopoly • The characteristics of the monopoly model are: • A single firm in the market. • That firm produces a unique product with no close substitutes. • Barriers to entry into the industry. • Firm has significant price control.

3. Monopolistic Competition • A different market structure that still reflects market power is monoplistic competition. • As its name implies it includes competitive as well as monopoly elements.

4. Monopolistic Competition • The characteristics of the monopolistic competition are: • A large number of firms in the market. • That each firm produces and sells a differentiated product with other firm’s products being close substitutes. • Low barriers to entry into the industry. • Firm has some price control but it is limited by the number of available substitutes.

5. Measurement of Market Power • Economists have developed several quantitative measures of the degree of monopoly power. These are frequently used in antitrust cases and the evaluation of mergers and acquisitions. They are: • Elasticity • Lerner Index • Cross-Price Elasticity • Herfindahl Index – not discussed

6. Defining the Market • Before discussing market power we must delineate the concept of a market. • To define a specific market one must identify the producers and products that (directly) compete for consumers in a specific area. These competing products must be perceived as “close” substitutes for one another.

7. Defining the Market for Coca-Cola • Is Pepsi in the same market? • Is Gatorade in the same market? • Is Budweiser in the same market? • Is Orange Juice in the same market?

8. Measuring Market Power:Elasticity of Demand • A price-taker had a perfectly elastic demand curve. • As elasticity increases, the ability to raise price and not lose substantial sales is diminished. • Thus, the elasticity coefficient gives an indication of market power. • The higher elasticity the lower the degree of market power and vice versa • Note we will show later that a firm will never operate in the inelastic portion of its demand curve.

9. The Lerner Index • The Lerner Index measures the extent that Price deviates from the price that would exist under perfect competition.

10. Lerner Index and Elasticity • Assuming profit maximization MR=MC. • Also we demonstrated that MR = P(1+1/E) in Chapter 3. Thus, Lerner Index is

11. Lerner Index • Under Perfect Competition the Lerner Index is zero. • The Lerner Index increases with the degree of market power. • The Lerner Index varies inversely with the elasticity of demand.

12. Cross Price Elasticity • The cross price elasticity serves as an indicator of market power – although not a direct measure of market power. • It measures the degree of substitutability between two products – the extent to which consumers view the products as substitutes. • The higher the cross price elasticity(positive assumed) coefficient – the less market power and vice versa.

13. Determinants of Market Power • Strong barriers to entry increase market power. Sources of these are • Economies of scale • Government created • Licenses • Franchises • Patents • Control of input supply • Brand loyalty

14. Profit Maximization under Monopoly Demand and Marginal Revenue in Monopoly P& MR($s) D Q MR

15. Profit Maximization under Monopoly Not the shutdown case. MC P& MR($s) P* D Q* Q MR

16. Short Run Equilibrium • Need to visualize possible short run cases. • No shutdown, produce where MR=MC as long as P>AVC for some level of output. • Profit Max if P>ATC • Loss Min if AVC<P<ATC • Shutdown, produce Q=0 and Loss= TFC • All but shutdown are shown in Figures 14.3 & 14.4

17. Long Run Profit Max • To max profits in the LR, the monopolist produces where MR=LMC unless P<LAC in which case exiting from the industry is the optimal decision. • The monopolist will general earn an economic profit in the long run since entry is restricted. • See Fig 14.5

18. Optimal Input Usage for the Monopolist • Same rule applies as before MRP = MC of the input(or wage rate if input is labor). • The only thing to be careful with is that MRP = MR*MP and in perfect competition since MR and P were the same we generall multiplied MP times the output price to get MRP. • In the case of monopoly we need to be sure MRP is the product of MR and MP.

19. Monopolistic Competition • Short run equilibrium(profit max) looks just like monopoly model SR equilibrium. The only difference is that the monopolistically competitive firm’s demand curve is more elastic(flatter?). • However, that difference is not discernible in our graphics.

20. Long Run Equilibrium in Monopolistic Competition • Given the ease of entry and exit, and the closeness of substitutes, in monopolistic competition firms will earn normal profits. • Thus, P = LAC. • However, P > LMC since LMC=MR and MR<P due to negative slope to demand curve. • See Fig 14.9 for graphic view.