CHAPTER 9 (midterm 2) Flashcards
What does it mean to have market power? *
Firms have an ability to influence the market price of a product (some pricing power)
What is the key difference between perfect competition and a market structure where firms have pricing power? *
The key difference is the presence of barriers to entry > factors that prevent entry into the market with large producer surplus
- normally in PC, producer surplus in the long run will induce additional firms to enter the market until it’s driven to zero
- the presence of barriers to entry means that firms in the market may be able to maintain positive producer surplus indefinitely
Name the 5 sources of market power we talk about
- Extreme scale Economies - Natural Monopoly
- Switching Costs
- Product Differentiation
- Absolute Cost Advantages or Control of Key Inputs
- Government Regulation
Explain extreme scale economies as a source of market power and barrier to entry
LATC curve?
What is the danger with this?
Extreme scale economies exhibit economies of scale at every quantity level
- LATC curve will be downward sloping > diseconomies (cost per unit increasing) never occurs
*Results in a natural monopoly (guaranteed to lead to monopoly)
> means that is it more efficient for a single firm to produce the entire industry output
> ex. there would be huge initial fixed costs and splitting output across multiple firms would just raise the average cost of production
*danger with this is quantity control and price control
Explain switching costs as a source of market power/barrier to entry
Presence of consumers’ switching costs > can result from:
- brand-related oppt. costs (ex. preferred status on an airline)
- technology constraints (ex. once you buy apple products it’s rly hard to change to something else)
- search costs (ex. switching health insurance plans is very complicated)
What are network goods?
A good whose value to each consumer increases with the number of other consumers of the product (ex. instagram)
Explain product differentiation as a source of market power / barrier to entry
For most non-commodity markets, consumers may not treat products from different firms as perfect substitutes
ex. in bicycle markets, potential bike buyers will have preferences between brands and they’re not all considered equal
Product differentiation refers to imperfect substitutability across varieties of a product
- means that firms can increase price a bit and not lose too many customers
Explain absolute cost advantages or control of key inputs as a source of market power / barrier to entry
- many production processes rely on scarce inputs (ex. natural resource products)
- a firm can have an absolute cost advantage over other firms in obtaining the key input
- controlling this input allows a firm to keep its costs lower than those of any other competitor
Explain how government regulation can limit entry to a market (examples)
- patents and copyrights
- licensing requirements (ex. medical board certification)
- prohibition of competition (ex. postal service) > this is meant to protect firms and encourage innovations and quality
do ABSOLUTE market powers exist?
no > if there is opportunity and profits being made, firms will find ways to break the barriers
Describe the demand curve that a monopolist faces and how can they increase output? How does this compare to other market structures? *
A monopolist faces a downward sloping market demand curve (bc they control all of the demand in the market)
> price is not fixed > and the only way to sell more of a product is to lower the price
> Oligopoly and Monopolistic competition are also associated with a downward-sloping demand
*monopoly will have the steepest demand curve
*PC : this is different from PC because the firm’s individual demand curve that they face is horizontal and they can sell as much as they want at the market price
Explain the shape of the marginal revenue curve and demand curve for a firm that has market power (and compared to PC) *
while in PC, the demand curve facing an individual firm is horizontal, and marginal revenue is equal to price (P=MR=horizontal demand curve)
*MR is constant
BUT, if a firm has market power, the demand curve will have a downward slope > this implies that the marginal revenue curve must also be downward sloping (because it is always decreasing as price decreases)
What happens to TR in market power when Price becomes too low?
When price becomes too low, TR starts to decrease
Why is marginal revenue NOT equal to price for a firm with market power (for a firm with a downward-sloping demand curve) *
Because when a firm produces more of a product, the price for ALL of its products in the marketplace has to fall
P > MR at each output level
*this occurs because we are considering a specific market (time and place) - decisions are made unit by unit, decisions are not sequential
What are the 2 components of marginal revenue for a firm with market power? (and consequentially for TR) *
- *Positive Effect
Increase in total revenue associated with an increase in sales
TR = PxQ
Q goes up so TR goes up - *Negative Effect
Decrease in total revenue associated with the fall in market price for all previously produced units of output
TR = PxQ
if Q goes up P must go down, so TR goes down for all units (if the P decreases enough, TR can also decrease)
Putting together the two opposing effects on MR of an increase in production, what mathematical equation can we get for MR? What does this tell us about the relationship between P and MR
MR = P + (change in P / change in Q) x Q
*because the part after the addition symbol will always be negative, this means that Price is always bigger than MR
When the demand curve is given: Q = A - BP, what is the inverse demand curve and then what is the MR curve? *
Inverse demand: P = a - bQ
MR = a - 2bQ
How do firms with market power maximize profits? How do they choose how much to produce? *
They will engage in production until MR = MC
(MR no longer equals P because production decisions influence price)
What are the 3 steps to determining the profit-maximizing quantity of production for a firm with market power? *
- Derive the MR curve from the demand curve (D curve to ID curve to MR curve)
- Find the output quantity at which MR = MC (MC will be given)
- Determine the profit-maximizing price by locating the point on the demand curve at the optimal quantity level (just plug the quantity into the inverse demand curve)
What is a markup? What is the Lerner Index?
The markup is the percentage of a firm’s price that is greater than its marginal cost > the extra amount a firm charges over its cost of producing the item
The Lerner Index is a measure of a firm’s markup, which indicates the degree of market power the firm enjoys
*relates markup to market power
What are the formulas for the markup and lerner index?
Markup = (P-MC / P)
Lerner index = - (1 / Ed)
Put them together to get the Markup Rule:
(P-MC / P) = - (1 / Ed)
(left side is a firm’s profit-maximizing markup)
What is the formula for the price elasticity of demand? what is considered inelastic and elastic?
% change in Q / % change in P
*should always be negative
inelastic = 0-1 in absolute value
elastic = greater than 1 in absolute value
Explain how a change in marginal cost (ex. MC = 200 > MC = 250) will impact the market with market power (how does it impact Q and Price)
Increase in marginal cost:
- if a given constant marginal cost increases, optimal quantity produced will decrease and Price will increase
Decrease in marginal cost:
- if a given constant marginal cost decreases, optimal quantity produced will increase and Price will decrease
What is the relationship between demand elasticity and a firm’s optimal markup?
As demand becomes more elastic, the optimal markup falls
Demand more elastic = more sensitive to price = elasticity of demand (Ed) gets higher in absolute value = lerner index (1/Ed) gets lower = markup gets lower
*this makes sense because the more sensitive consumers are to price changes (more elastic), the less the firm can take advantage of them
*so the firms with the highest Lerner index have the most market power
