L3 - Market Power and Dominant Firms

Question 1

Generally, what does a competition agency need to do first before deciding whether a firm is dominant?

Answer 1

• they need to firstly define the market and then look at market shares

Question 2

What does it mean that a firm is dominant in a market?

Answer 2

OFT –> Office of Fair Trading (combine into the Competition and Markets Authority)

• dominant firm must have substantial market power –> this is the ability for a firm to set price above marginal costs
  
  • rivals must be relatively weak in comparison to the firm or it must enjoy a large and stable share of the market
• Sort of grey area between 40-50% market share on whether the firm is dominant or not
  
  • In this case need to do some more analysis to find out whether it is or isn’t

Question 3

Other indirect measures of market power?

Answer 3

• market share has been seen as an indirect measure of market power
  
  • these are two others: concentration ratio and Herfindahl-Hirschman index
• Concentration ratio –> sum of the markets shares of the largest firms in the market
  
  • only partial helpful as it doesn’t talk about how market share is spread across the firms –> the example has the same concentration ratio but the markets look very different
• HHI –> sum of the market shares squared (all firms)
  
  • Gives us information about how market share is spread across firms
    
    • The highest is a monopoly at 1, smallest is an even share between symmetric oligopolies –> the higher the number means that a firm holds more of the market share
  • Euro uses the decimal place convention for markets share whereas the US uses exactly number so 1 = 100% in this case

Question 4

How do competition agencies define a market?

Answer 4

• A market includes all products (in a geographical area) that exert competitive pressure on each other
• DEFINING A MARKET: SSNIP test (or hypothetical monopolist test) –> a thought experiment
• SSNIP –> Small but significant non-transitory increase in prices (5-10% increase)
  
  • Identify all products that are close substitutes
  • Suppose a hypothetical monopolist owns a number of stores/products Could it sustain a small but significant non-transitory increase in prices (SSNIP)? (i.e. a price increase between 5-10%)
    
    • ● if yes, then stores/products owned by a hypothetical monopolist defines the market
    • ● if no, then there must be competitive pressure, so the market definition is wider
  • So include next closest substitute, & repeat until a SSNIP could be sustained
  • Relevant market = smallest product group such that SSNIP profitable for a hypothetical monopolist

Could Y and Z raise their price? Well X is pretty close and they could lose their customers to them –> So X must be included in the market

As W and V are far away we could say they could raise their prices and thus X, Y and Z are therefore defined as the market t

• Difficulty in doing the SNNIP test –> define it too widely and you would get too small of a market share, too tightly and you would get too high of a market share
  
  • Tesco defined as a groceries national hold 35% of the market, but looking at local towns (like Loughborough) or home it is usual holds 50% or more!!

Question 5

What important concepts are needed when working on the data for a SSNIP test?

Answer 5

Question 6

What is the Cellophane fallacy with respect the SSNIP test?

Answer 6

• paradox arises in a market with few close substitutes (low cross price elasticity)
  
  • Thus can increase prices above the competitive level without losing too much demand
  • Yet at some level of prices more and more subistutes will arise and consumers are no longer willing to pay the new highest price
• Arose from a US Supreme court case –> Cellophane was a DuPont company plastic wrapping product that had its production restricted to just itself by numerous patents in the 1950s
  
  • They were sued for monopolisation of the Cellophane market but the court ruled that when when evaluated at the monopolist price DuPont used their were actually many substitutes for Cellophane under the SSNIP test —> DuPont held a small portion of the market for wrapping materials and held little to no market power
• A later article in the American Economic Review pointed out the mistake of a monopolist inability to increase prices from its current level as a lack of market power rather than them exceeded consumers willingness to pay for that product –> neglects to consider the fact they have already exerised this market power from the competitive to the monpolist level of prices already
  
  • If the supreme court consider the substituability of Cellophane the the competitive price the sales of other wrapping would have be lower and DuPont could have been fined for holding a monopoly over the market

Question 7

What is the Lerner index of market power?

Answer 7

• Why isnt it easy to define the relationship between market power and market shares? –> price data in the market is not always available, and marginal cost is inherently unobservable,
  
  • We can derive this from accounting statements but that doesn’t take in account all of the economic costs to the firm either
• So to do this we are going to build a theoretical model that extents the Lerner Index
• Can get the Lerner index from setting up a monopoly’s profit function differentiating it and setting it equal to zero and rearranging
• Lerner index tells us as demand becomes more elastic, the Lerner index is going down and the distortion between price and MC is getting closer to zero

Question 8

Assumption of the Dominant firm with a competitive fringe (DFCF) model?

Answer 8

Question 9

Step 0: Supply of the Fringe

DFCF model

Answer 9

• In the exam we won’t have to do step 0 –> only being given it to help our understanding
• Step 0 –> deriving the supply curve of the fringe
  
  • Upwards sloping average costs curve means the diseconomies of scale kick in from the moment it starts producing
  • So how much can one firing firm supply at a given price?
    
    • For a given price (say p4), a fringe firm is a price taker, so its demand curve is completely elastic (MR = AR), at the point MR = MC is the quantity at which the firm would supply
      
      • Doing this for all the fringe firms in the market will give us the total quantity that they are willing to produce at that price
    • Doing this for a various number of prices will help us determine the fringe’s total supply curve
      
      • Nothing is produced at p2 as MR=MC = 0

Question 10

Step1: residual demand curve

DFCF model

Answer 10

• below the Fringe’s supply ( where is cross the y-axis on the left graph) –> The dominant firm would supply at the market
• above this point the fringe will start supply the market
  
  • The dominant firm will then supply the different between market demand and the fringe’s supply at every single above this point
• At a high enough price where the Fringe’s supply = Market demand, the dominant firm will supply nothing as all demand is already met by the fringe firms
• This creates the dominant’s firm’s residual demand

Question 11

Step 2: Dominants firm’s optimal output

DFCF Model

Answer 11

Question 12

In a numerical question, How would you find the dominant firm’s residual demand curve and profit function?

DFCF model

Answer 12

1. residual demand curve
   
   1. Q^D= Q^m - Q^F
      
      1. Find the demand curve based off the difference between the market demand curve and the fringe
2. Profit function, p* and Q^D*
   
   1. Set up profit function as normal –> TR - TC
      
      1. Make sure you are using only costs related to the dominant firm
   2. Differentiate, set equal to zero, and rearrange to find p*
   3. Sub p* into the residual demand curve to find Q^D*

Question 13

What is the Lerner Index of the dominant firm?

Answer 13

• When we have differentiated the firm’s profit function we used the product rule with respect to p, where the cost function (as it is a function of a function we also have to use the chain rule
• Interpretation 1
  
  • With an increase in p, they make more money due to selling each unit at a higher price but are losing the price-cost margin on the units it no longer sells
    
    • This is the trade-off it faces when a firm wants to raise its price
• 2nd slide
  
  • We have subbed in for the first-order conditions of the difference of the market quantity to fringe quantity for the dominant first first-order differential on quantity
• May not need to know the proof of the Lerner Index for the exam but would need to explain the intuition of the various important determinants of the dominants firms market power
• In the Lerner index –> sⁱ is the market share of demand, ε is the price elasticity of demand, ε^f_s is the elasticity of supply of the competitive fringe
  
  • The more elastic the fringes supply curve is, the small the price-cost margin is –> as a small increase in price would lead to even more of the market being supplied by the fringe –> thus the L_D falls when this rises –> Greater the competitive rivalry it places on the dominant firm

Question 14

What is the case where there isnt a relationship between market power and market share?

Answer 14

• Under certain conditions, if a monopolist sell a durable good, it will have no market power and have to price at MC
• Consumers are happy to wait for the good to drop in price before they decide to buy it

Question 15

How do durable goods erode the market power of monopolist?

Answer 15

• The price that a firm’s sets initially will affect demand later on
  
  • Say in period 1 it sets a price p’, it will receive the demand q’
  • In period 2, the monopolist will receive no demand for and price greater than or equal to p’ –> this is because everyone that was willing to buy at that price has already bought the good thus there is no demand left at those price points
  • The lower the price the lower the demand in period 2
• ​This a crude analysis as consumers are non-strategic –> they are buying when they can and not thinking whether they should wait till the next period to buy the good
  
  • Do consumers have an incentive to delay purchases?
  • one definitely does. The consumer that buys the last good at p1, which is their maximum willingness to pay –>thus if they buy in period 1, their surplus would be zero
  • BUT if they are willing to wait till period two, they would only have to pay p2 –> which will generate a positive consumer surplus for them

Question 16

So why should a consumer delay the purchase of a durable good?

Answer 16

• So IF there is an infinite number of periods and IF the product lasts forever and IF it is not costly for the consumer to wait (delta =1) then the monopolist cant price above MC
  
  • WHY? Because the consumer simply waits until prices fall to MC

Question 17

Strategies to avoid the Coase conjecture?

Answer 17

• 1. Leasing
     * If product is returned, monopolist can supply consumers with high WTP againProblems: moral hazard
• 2. Invest in reputation
     * Examples: Disney animations, Star Wars
• 3. Most-favoured-customer clause
     * (If price is lower tomorrow, we’ll refund the difference!) Firm doesn’t want to lower price (commitment device) Consumers may as well buy
• 4. New customers
     * Increase demand in period 2, increases price in period 2…
• 5. Reduce the good’s durability
     * If product breaks, consumers with high WTP may return next period
     * Apply has been accused of this –> older phones slow down and arent as compatible with newer software

Question 18

Deriving the Lerner Index for a monopolist?

Answer 18