Lecture 10
Markets with market
power
Four idealized types of market
structure
• Perfect competition: many sellers; they are selling an
identical product
• Pure monopoly: only one seller
• Monopolistic competition: many sellers, selling
slightly different goods/services
• Oligopoly: only a few sellers; each needs to watch what
the others are doing
Pure monopoly
• Conditions:
– There is only one seller
– The good has no close substitutes
– Barriers to entry prevent other firms from starting to
produce the good
• Barriers to entry: economic, legal, or deliberate
obstacles that keep new sellers from entering a market
Pure monopoly: Barriers to entry
• Economic barriers: related with the production
technology (high fixed costs, economies of scale, network
externalities. Ex: natural monopoly)
• Legal barriers: copy rights, franchises, patents,
trademarks
• Deliberate barriers: physical, financial, and political
intimidation of potential competitors. Many are illegal (Ex:
predatory pricing, dumping, exclusionary practices)
Pure monopoly: Profit maximization
Marginal Revenue for a Monopolist
Quantity of
Output
1
2
3
4
5
6
7
8
9
Selling Price
($)
44
40
36
32
28
24
20
16
12
Total Revenue
($)
44
80
108
128
140
144
140
128
108
Marginal Revenue
($)
44
36
28
20
12
4
4
12
20
Pure monopoly: Profit maximization
Pure monopoly and inefficiency
Can monopoly be efficient?
In some cases, the efficiency cost of monopoly may not be as
bad as the previous analysis suggests:
• Natural monopoly: A single big firm may sometimes be
socially preferable compared to many small ones.
• Intellectual property: Firms may need a period of exclusive,
high profits in order to cover the costs of research and
development
• When there is some pressure to appear competitive,
monopolies may tend to reduce the price and increase the
quantity that it produces
• Perfect price discrimination: A monopolist able to charge
different prices to its customers based on their willingness to
pay would be efficient.
Can monopoly be efficient?
Price discrimination:
A seller charging different prices to
different buyers, depending on their
ability and willingness to pay
Perfectly price discriminating
monopolist:
an extreme form of price
discrimination
Monopolistic competition
• Conditions:
– Many sellers and buyers
– The sellers produce slightly different products
(product differentiation)
– Sellers can freely enter and exit
– Buyers have perfect information
Monopolistic competition: Profit
maximization
Price
MC
D1
MR 1
D2
MR 2
Quantity
Monopolistic competition: Long-run
efficiency
Oligopoly
• Conditions:
– Only a few sellers control the market
– Entry is difficult
• Concentration ratio:
The share of total production, sales, or revenues attributable
to the largest firms in an industry (usually the share of the
largest four firms)
Examples (from year 2002):
Car and light-truck manufacturing in the US: 88.1%
Breakfast cereal manufacturing: 78.4%
Credit card issuing financial firms: 75.8%
Oligopoly: Behavior of firms
• The behavior of oligopolistic firms is
interdependent; marginal thinking that we used so
far not applicable anymore
• Therefore, game theory needed to analyze the
behavior of oligopolistic firms (due to strategic
interaction between firms)
Oligopoly: An example with a Duopoly
Firm 2’s Options
Firm 1’s Options
Low Price
High Price
low profit
loss
Low Price
low profit
high profit
high profit
moderate profit
High Price
loss
moderate profit
Assume that the firms are non-cooperative: They are
rivals and do not communicate or cooperate with each other
This payoff matrix shows possible outcomes for each of the two players,
depending on the strategy each one chooses
Oligopoly: Collusion, cartels, etc.
• Collusion: Cooperation among potential rivals to gain
market power as a group
• Cartel: explicit collusion (Example: OPEC)
• Tacit collusion: collusion that takes place without
creation of a cartel (without a formal organization)
• Price leadership: a form of collusion in which many
sellers follow the price changes instituted by one
particular seller
Oligopoly: Efficiency?
• Inefficient like pure monopoly
• Maybe even worse sometimes:
Because no possibility of reaping advantages
of economies of scale
Summary: 4 types of idealized market
structures
Summary of Traditional Market Structures
Number of
Sellers in the
Market
Type of Item(s)
Sold
Market Power of
an Individual
Seller
Entry Barriers
Long-Run
Economic Profit
ProfitMaximizing
Condition
Perfect
Competition
Pure Monopoly
Monopolistic
Competition
Oligopoly
many
one
many
few
identical
unique
differentiated
varies
none
very high
some
substantial
none
very high
none
some
zero
positive
zero
varies
MC = P
MC = MR
MC = MR
varies