Market Power
Chapter 5
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.
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.
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
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
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?
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
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.
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
Competitive Markets
An industry operates in a competitive market if it has
1) Many buyers and sellers that cannot affect the market price
2) Easy entry of new producers entering in response to economic
profits
3) Firms producing very similar products
4) Buyers and sellers having perfect information about market
conditions
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.
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
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.
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?
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
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!
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 allows exercising of
market power by raising market price?
Trend in Market Power
• Shepherd’s study of US economy, 1939-1980: market power has
decreased for the following reasons:
1) 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
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
1. Natural monopolies: only one firm can profitably supply the market
2. Control of essential input: diamonds in South Africa, bauxites in
aluminum industry
3. Product differentiation: product varieties capture consumers
4. Government: patenting, Postal Service, import tariffs, quotas,
professional licensing (taxis, physicians)
5. Superior product: Wal-Mart, Microsoft,
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
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
OPEC Cartel and World Production of Oil
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
Cooperation Difficulties in a Cartel
Cooperation in a cartel becomes more difficult if
1. Number of firms in industry increases
Detecting a cheater is more difficult
The holdout problem: some firms may refuse to cooperate
2. Firms become less similar
Cost-efficient firms will want larger profit shares
OPEC: New Entry
1. 11 member and 6-10
nonmember countries
Price surged from $3 to $30 per
barrel during 1970s
New entry occurred
2. Given enough time, suppliers
will adjust to change the
shape of the supply curve!
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
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
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
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
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
Government and Market Power
General principles to guide government policy toward market power:
1) Limit mergers of firms producing very similar products
Anti-trust laws
Mergers in the refinery sector resulted in more efficient firms
2) Grant patents to support basic research (encourage economic
rent-seeking in the knowledge-producing sector)
3) Discourage political rent-seeking to preclude government from
becoming a source of market power itself
License system and the asymmetric information problem