Chapter 9 - Market power and monopoly

Question 1

1. When does a firm have market power?

Answer 1

A firm that can influence the price at which it sells its product holds market power. Firms that have the ability to set and maintain a price above average cost, also in the long run.

Question 2

Define monopoly and monopolist

Answer 2

A monopoly is a market served by only one firm. A monopolist is the sole supplier and price setter og a good on the market.

Question 3

2. Name and describe five barriers to entry to a market.

Answer 3

Industries with market power have barriers to entry that prevent new firms from entering the market:

a. Natural monopolies-or markets in which it is efficient for a single firm to produce the entire industry output-serve as effective barriers to entry to other firms. (The incumbent’s size usually gives it a cost advantage).
b. A switching cost makes it less likely a consumer will switch from one business or product to another, since the consumer will have to give up something in order to make the switch. Examples are brand-related opportunity costs, technology constraints and search costs. The most extreme switching cost - a network good (a good whose value to each customer rises with the number of other consumers who use the product).
c. Differentiation among products creates an imperfect substitutability across otherwise similar products. As a result, new entrants to the market cannot gain customers simply by selling their product at a lower price.
d. A firm’s control of key inputs (absolute cost advantage) also will prevent entry into the market. If a firm has control of a key input, that means it has some special asset that other firms do not have.
e. Government regulation e.g. licensing requirements, patents and copyrights, prohibition of competition (e.g. pharmacies in DK)

Question 4

3. What are the characteristics of a natural monopoly? Why is it efficient for society for a natural monopoly to produce all the output of an entire industry?

Answer 4

Natural monopolies face economies of scale at all output levels i.e. the firm’s long-run average total cost curve is always downward-sloping. This means that the larger the firm is, the lower its average total costs (even if it sells the entire market quantity itself).

If all the firms in an industry have this same cost structure (high fixed costs and constant or slowly rising marginal cost), splitting industry output among different firms would increase average total costs, making it most efficient for one firm to produce the entire industry output. (Each firm that operates have to pay fixed costs)

Question 5

How can natural monopolies disappear?

Answer 5

If demand changes sufficiently over time. Demand can rise so much that average total cost eventually rises enough to enable new firms to enter the market.

Question 6

Describe oligopoly and monopolistic competition and the difference between these and monopoly

Answer 6

Oligopoly - market structure in which a few competitors operate
Monopolistic competition - market structure with a large number of firms selling differentiated products
The difference between monopoly and these other two cases is that in oligopoly and monopolistic competition, the particular shape of the demand curve faced by any given firm (even though it still slopes down) depends on the supply decisions of the other firms in the market. In a monopoly, there are no such interactions between firms, and so the firm’s demand curve is the market demand curve.

Question 7

Describe marginal revenue in relation to a seller with market power

Answer 7

Because the firm faces a downward-sloping demand curve, it can only sell more of its good by reducing its price. They restrict output to keep prices higher.
The concept of marginal revenue is more subtle for a seller with market power. The extra revenue from selling another unit is no longer just the price. Yes, the firm can get the revenue from selling one more unit, but because the firm faces a downward-sloping demand curve, the more it chooses to sell, the lower the price will be for all units it sells, not just that one extra unit (here the firm is not allowed to charge different prices to different customers). This reduces the revenue the firm receives for the other units it sells. When computing the marginal revenue from selling that last unit, then, the firm must also subtract the loss it suffers on every other unit.

Question 8

Which demand curve does a monopoly face?

Answer 8

A downward sloping demand curve.

Question 9

What is the profit for a monopoly?

Answer 9

Monopoly profit from output Q: π(Q)=P(Q)Q-C(Q) where revenue is P(Q)Q and cost is C(Q). P(Q) is inverse demand. Revenue of a monopolist differs from revenue of a firm under perfect competition as price depends directly on output.

Question 10

What is the formula for marginal revenue for a monopolist? Explain the components

Answer 10

Marginal revenue equals: R’(Q) = P(Q) + P’(Q)*Q or MR=P+(∆P/∆Q)·Q
Revenue gain from output expansion at given price P(Q)
Revenue loss from price reduction P’(Q) for previous level of output
Slope of demand curve, P^’ (Q), reflects buyers’ price sensitivity; MR falls faster
for higher P^’ (Q).
∆P/∆Q or P’(Q) is negative, which means that marginal revenue will always be less than the market price. Furthermore, the change in price corresponding to a change in quantity is a measure of how steep the demand curve is. When the demand curve is really steep, price falls a lot in response to an increase in output. When the demand curve is flatter, price is not very sensitive to quantity increases.
Firms that face steep demand curves obtain small revenue gains (or even losses) when they increase output and vice versa.
Perfect competition is just the special case in which the firm’s demand curve is perfectly elastic, so MR=P.
The first term is the additional revenue from selling an additional unit at price P.
We can apply the formula for marginal revenue to any demand curve. For nonlinear demand curves, ∆P/∆Q is the slope of a line tangent to the demand curve at quantity Q. But the formula is especially easy for linear demand curves, because ∆P/∆Q is constant.

Question 11

What is the expression for the marginal revenue of any linear demand curve?

Answer 11

MR=a-2bQ - for the inverse demand curve
This formula shows that marginal revenue varies with the firm’s output. (The only exception is for a perfectly competitive firm)

Question 12

4. Describe the connection between the slope of the demand curve for a good and a firm’s marginal revenue.

Answer 12

Just as the demand curve shows the relationship between a good’s price and its quantity, the marginal revenue curve shows the relationship between a good’s marginal revenue and its quantity. The marginal revenue curve of a linear demand curve is also very similar to a demand curve on other dimensions: Its vertical intercept is identical, and its slope is twice the slope of the demand curve

Question 13

5. What is the profit-maximizing output level for a firm with market power?

Answer 13

A profit-maximizing firm produces where marginal revenue equals marginal cost. If marginal revenue is above marginal cost, a firm can produce more and earn more revenue than the extra cost of production and increase its profit. If marginal revenue is below marginal cost, a firm can reduce its output, lose less revenue than it saves in cost, and again raise its profit. Only when these two marginal values are equal does changing output not increase profit.

The demand curve ties together price and quantity, so pocking one implies the other.

Question 14

Why can a firm with market power not profitably charge whatever price they want to ?

Answer 14

A firm with market power can keep raising its price (or equivalently, keep cutting its output), but if the firm raises the price too much, its customers will stop buying - even of there are no other competitors. A firm is limited by the demand for its product. Because the demand curve is downward-sloping, a rise in price means a decline in quantity demanded.

Question 15

Explain a three step mathematical approach to profit maximization with market power

Answer 15

Step 1: Derive the marginal revenue curve from the demand curve. First obtain the inverse demand curve. If it is linear remember MR = a - 2bQ i.e. the MR curve is twice as steep.

Step 2: Find the output quantity at which marginal revenue equals marginal cost. Set MR = MC.

Step 3: Find the profit-maximizing price by plugging the optimal quantity into the demand curve.

Question 16

What is marginal profit at the optimal level for a monopolist and how can we calculate it?

Answer 16

Marginal profit is 0. Marginal profit can be calculated as
Marginal profit=(P^M-c)/P^M =-∆P/∆Q·Q^M/P^M
The left side is the mark up. And the left side is -1/the elasticity of demand

Question 17

What is the Lerner index? And what is the formula?

Answer 17

The Lerner index is a measure of a firm’s mark-up, or its level of market power.
(P-MC)/P=-1/E^d

The left-hand side of the equation equals the firm’s profit-maximizing mark-up, the percentage of the firm’s price that is greater than its marginal cost.

At monopoly price, the Lerner index is inversely related to absolute value of price elasticity of demand (-E^D)

This equation indicates that this mark-up should depend on the price elasticity of demand that the firm faces. Specifically, as demand becomes more elastic - Ed becomes more negative or larger in absolute value - the optimal mark-up as a fraction of price falls.

Because the ability to price above marginal cost is the definition of market power, the Lerner index is a measure of market power. The higher it is, the greater the firm’s ability to price above its marginal cost. Market power is limited by the market (e.g. very elastic demand dives low market power).

Question 18

What happens in the case of perfectly elastic demand in relation to the Lerner index?

Answer 18

When demand is perfectly elastic - the firm faces a horizontal demand curve and any effort to charge a price higher than the demand curve will result in a loss of all sales. The Lerner index is zero in this case, which means the mark-up is also zero. The firm sells at a price equal to marginal cost, and the firm becomes a price taker.

Question 19

What happens in the case where a firm faces a demand curve that is inelastic or unit elastic in relation to the Lerner index?

Answer 19

In this case, the Lerner index is greater than 1. But this would imply that P - MC > P, or MC < 0, and marginal cost can’t be negative. The basic economic explanation is that a firm should never operate at a point on its demand curve where demand is inelastic or unit elastic. (In the linear demand case, demand becomes less elastic as price falls.) Think about what would happen if a firm was setting a price (or a quantity) that put it on an inelastic or unit elastic portion of its demand curve, and then decided to increase its price. By definition, because demand is inelastic, whatever the percentage increase in price, the percentage drop in quantity will be smaller (or will exactly equal the percentage increase in price if demand is unit elastic). This means that the price increase will raise the firm’s revenue ( or not change it if demand is unit elastic). At the same time, because the firm is producing a smaller quantity, its total cost must fall, because costs increase in quantity. So, the price increase raises the firm’s revenue while lowering its cost. In other words, the firm is guaranteed to raise profit by increasing prices as long as demand is inelastic. Thus, it can’t be profit-maximizing to set a price where demand is inelastic.

Question 20

What happens to revenue if output is increased and the demand is elastic or inelastic?

Answer 20

Output rise increases revenue if demand is elastic (E^D-1)

Question 21

How does a firm with market power react to market changes (compare with perfectly competitive firms)?

Answer 21

The changes in quantity supplied and price created by cost and demand shocks have the same direction, but different magnitudes, for firms with market power as for perfectly competitive firms. However, firms with market power respond differently to changes in consumers’ price sensitivities-that is, rotations in the demand curve-than do perfectly competitive firms. [Section 9.4]

Question 22

Specifically, what happens if there is a change in marginal cost?

Answer 22

If only the supply side of the market is affected, the consumer’s willingness to pay does not change, and the demand and marginal revenue curves do not shift. A firm with market power responds to a cost shock in a way that is similar to a competitive firm’s response. When marginal cost rises, price rises, and output falls. When marginal cost falls, price falls, and output rises. But in perfect competition, a change in marginal cost is fully reflected in the market price, because P = MC. That does not have to be the case when the seller has market power. The drop in quantity that results from the increase in cost is also smaller than the drop that would occur in a perfectly competitive market. Note, however, that the equilibrium quantity is still higher in a competitive market than one with market power, even after the cost increase. It’s the change in Q that is smaller.

Question 23

What happens if there is a change in demand?

Answer 23

Because the demand curve has shifted in this case, the marginal revenue curve changes as well. An outward shift in demand leads to an increase in both quantity and price in a market where the seller has market power, the same direction as in perfect competition. But again, the size of the changes differs.

Question 24

How do firms with market power react to a change in the price sensitivity of demand - that is making the demand curve steeper or flatter?

Answer 24

With perfect competition, flattening the demand curve does not change the point at which P = MC, so neither price nor quantity moves. The price sensitivity of consumers does not impact the seller’s output decisions as long as price is still equal to marginal cost.
With market power, the rotation in demand also moves the marginal revenue curves. Therefore, the firm’s output rises as a result of the demand curve rotation and the price falls (consumers more price sensitive). The opposite pattern holds when consumer become less price-sensitive and firms have market power: output falls and price rises.

Question 25

6. Why do firms with market power have only demand-and not supply—curves?

Answer 25

Firms with market power face a set of profit maximizing prices and quantity combinations, but these combinations do not, strictly speaking, form a supply curve. These price-quantity combinations depend on the firm’s demand curve, while a supply curve by its formal definition exists independent of its associated demand curve.

Question 26

7. Firms with market power respond differently to changes in consumers’ price sensitivity than do perfectly competitive firms. Explain why this is true.

Answer 26

In perfect competition, suppliers’ production decisions are independent of the price sensitivity of demand. This is not true for decisions made by firms with market power. A change in the price sensitivity of demand rotates the demand curve, thereby rotating the firm’s marginal revenue curve. The firm’s profit maximizing price-quantity combination is now at the intersection of the new marginal revenue curve and the marginal cost curve.

Question 27

How is market power great for firms and bad for consumers?

Answer 27

Firms can earn more producer surplus by restricting output and raising price, but this costs consumers a sizable chunk of their consumer surplus.

Question 28

8. Compare the consumer and producer surplus of perfectly competitive firms with that of firms with market power.

Answer 28

A perfectly competitive firm faces a market price equal to its marginal cost, and thus does not earn producer surplus. A firm with market power is able to price above its marginal cost; as a result, it earns producer surplus, at the expense of some of the consumer surplus that would benefit buyers under perfect competition.

Question 29

9. Why does the profit-maximizing strategy of a firm with market power create a deadweight loss?

Answer 29

The dead weight loss represents the inefficiency of market power: There are consumers who demand the product at a price above its marginal cost but below the higher price set by the firm with market power. The resulting loss in surplus from these consumers who do not purchase the product under monopoly is the deadweight loss.

Question 30

Why is producer surplus higher when the demand curve is steeper?

Answer 30

Because, a steeper demand curve raises the firm’s profit-maximizing mark-up of price over marginal cost.

Question 31

10. Name some regulations the government imposes on firms with market power.

Answer 31

Governments use a variety of regulations to restrict market power and decrease deadweight loss, including:

a. Direct price regulations that set the price that a firm may charge in a market.
b. Antitrust laws that restrict firms from behaviours that limit competition in a market.

Question 32

What is the relationship between the monopoly price and the Lerner index?

Answer 32

At monopoly price, the Lerner index is inversely related to the absolute value of price elasticity of demand (-E^D)

Question 33

How does elasticity relate to market power?

Answer 33

Market power is limited by the market (e.g. very elastic demand gives low market power)

Question 34

What happens if a tax is imposed on a monopolist?

Answer 34

The marginal cost increases by the tax

Question 35

What is the marginal revenue of one additional unit for a monopoly?

Answer 35

MR = ∆TR/∆Q