Market Power Flashcards
Compare a competitive firm and a monopolist
Under perfect competition, there are many producers and consumers, each too small to influence the market. Firms are price takers which sell as much or as little as they want at a price decided by the industry. In a competitive market, profit maximisation: P = MR = MC such that producing an additional unit would be covered by the profit gained from selling the additional unit.
Compared to the homogenous good in the competitive market, there is no one else producing the same good in a monopoly, giving it the market power to raise the price of its product without losing all its sales to rivals. As a result, monopolies are able to set prices by adjusting the quantity of good that it supplies. However, the market demand ($ and quantity available) prevents monopoly from charging super high prices with high quantities.
In order to sell more units of the good, the monopoly has to lower the price for additional units sold, this reduces the revenue on units they are already selling. Thus, marginal revenue is less than price. Aiming for profit maximisation, monopolies produce where MC = MR. This is because MC<MR, and increasing an additional unit of output leads to higher profit → so firm should increase output. When MC>MR, there is a loss so firms will reduce output to increase profit.
Why is a monopoly inefficient/a type of market failure?
Socially efficient quantity occurs when P/MB (value of the good to consumers) = MC (cost incurred from production). Below efficient quantity, MB>MC (value to buyers is greater than cost to sellers, increasing output will raise total surplus) and above efficient quantity MB<MC (value to buyers is less than the cost to sellers, decreasing output will raise total surplus).
However, monopoly produces at MR = MC which is at a lower quantity than P = MC. The inefficiently low quantity leads to an inefficiently high price. When P > MC, consumers who value the good > MC but < P are unable to afford the good, leading to deadweight loss.
Sources of market power
1) Barriers to entry
2) Gov-granted monopolies (water system, patent drugs, rail construction)
3) Network externalities
4) Natural monopolies
5) Mergers and acquisition
Natural monopolies
A natural monopoly is a market in which the market demand is only large enough to support only one large firm operating at or near its minimum efficient scale of production (MES).
Barriers to entry
Barriers to entry are artificial (strategic or statutory) or natural barriers that prevent firms from entering a market.
Natural BTEntry arise from differences in scale of production and costs between the incumbent firm and a potential entrant.
The incumbent firm operates on a larger scale of production and is able to exploit EOS more fully and enjoy a much lower LRAC compared to a potential entrant which operates on a smaller scale. Hence, the high startup cost such as the cost of building factories and plants deter potential entrants from entering due to higher AC.
2) Artificial barriers to entry include strategic and statutory barriers
a) (Gov-granted monopolies) Strategic barriers: Any move by the incumbent to keep potential firms out of the market including limit pricing, gaining control over raw materials, hostile takeovers and acquisitions, R&D, intensive advertising and branding
b) Statutory barriers: legal protections a firm attains to retain its market share, comes in the form of patents and copyrights. For instance, drug companies attain patent protections that give them the exclusive right to produce and sell certain types of drugs for a period of time. Due to these protections, there are only a small number of firms with large market share, and thus each firm has quite large price setting ability as they are able to set the price at significantly higher level than marginal cost. This keeps demand high and relatively less price elastic, allowing the firm to enjoy a period of supernormal profits. Thus potential entrants are legally restricted from entering the industry until the patents expire.
Predatory pricing
Deliberate strategy of driving competitors out of the market and scaring off potential entrants by setting very low prices or selling below its AVC in the short run.
The firm could charge a price very low and even sell below its own AVC and as such smaller competitors are forced to shut down as TR<TC in the long run if they try to match the prices set by the incumbent, and have no past supernormal profit to draw on to survive. This is unlike the incumbent which has accumulated past supernormal profit and also enjoy lower unit cost of production as a result of reaping substantial economies of scale.
- In doing so, potential entrants are also scared off. Afterwards, the incumbent firm will be able to enjoy increased demand as industry demand is now divided across a smaller number of firms.
Limit pricing
Pricing by the incumbent firm (s) to deter entry or the expansion of fringe (smaller) firms by setting a price below the profit-maximising price but above the competitive level (below potential entrant AC) (above AVC, unlike predatory pricing).
The incumbent firm is willing to sacrifice profits in the short run to prevent entry.
If they were to enter and price similarly as the incumbent firm, they would make subnormal profits and might not have the resources to sustain those losses until they can reach a competitive level of average cost through scale economies.
Potential firms may decide that the risks of entering the industry are too high and this would thus deter them from entering the industry.
Growth strategies
1) Mergers and acquisitions: Forms of external growth occur when a firm combines with one or more existing firms to form an entirely new enterprise or buys over another firm.
2) Horizontal integration: Horizontal Integration occurs when a firm combines with or takes over a similar firm at the same stage of production to form a single entity.
By expanding its scale of production towards MES, it enjoys lower AC since it can now fully exploit iEOS. (Ex Grab’s acquisition of Uber in South East Asia)
3) Vertical integration: Vertical Integration includes both forward and backward integration. It occurs when a firm combines with or takes over another firm at a different stage of production, controlling more than one stage of production. This allows the firm to set itself apart from its rivals.
4) Conglomerates: Conglomerates are companies that sell goods that are not directly related to one another. The firm may choose to grow and expand into conglomerates for diversification purposes so that its revenue will be overly affected by a decrease in demand for any of its goods and services, reducing uncertainty and risks.
Price Discrimination
Business practice of selling the same good at different prices to different customers, according to their willingness to pay.
Conditions:
1) Firm must have market power to set prices
2) Firm must have the ability to identify and segment the market based on differences in PED/their willingness to pay
3) Firm must be able to prevent arbitrage (buying a good at a lower price and selling it at a higher price)
This allows firms to maximise revenue by capturing all of consumer surplus through setting prices higher in markets with PED<1 and lower prices in markets with PED>1 as a decrease in price leads to a more than proportionate increase in quantity demanded.
Deadweight loss and consumer surplus is removed to become additional monopoly profit.
Social costs: Are monopolies a problem?
Monopolies profit due to higher price not a problem for society, as it involves a transfer of wealth without affecting the overall market surplus. The issue is that it is producing below the socially optimal level, causing inefficiency and generating deadweight loss. These social costs include the cost incurred by a monopoly in hiring lobbyists to maintain its position and keep prices above marginal costs.
(1) Monopolies do not achieve their dominance for no good reason:
- Products need to be created with significant investment
- The inefficiency would not even exist were it not for the prospect of monopoly profits
Some products would not even exist without the prospect of appropriating economic rents
- Entry barriers created by product improvement are not against consumer welfare
(2) Is perfect competition desirable in real life?
P=MC for digital products captures little of the benefits consumers can get from the good
Impossible to be attained because the marginal cost of providing operational systems and softwares is infinitely small
If all markets were perfectly competitive, what kind of entrepreneur would want to join them?
No economic profit to incentivise entrepreneurs
Oligopolies
An oligopolistic market structure is one that is characterized by high barriers to entry (BTE), few dominant firms selling homogenous or differentiated products and possess imperfect information in terms of rivals pricing, output decision processes. Due to the small number of firms in the market, the actions of one firm can affect the other firms’ market share and therefore pricing and output decisions of other firms significantly. There is a large degree of mutual interdependence and rival consciousness so each firm recognises that it has to take into account the behaviour of its competitors when it makes decisions.
As a result, they tend to engage in collusive actions such as formation of cartels like OPEC so as to reduce uncertainty and maximise profits. Firms tend to focus on non-price competition in order to reduce the substitutability of their products so as to reduce the value of CED so they are less affected by price changes by rival firms and also to gain more market share
Herfindahl-Hirschman Index
measure of how concentrated a market is - Moves from 0 to 1; Herfindahl index < 0.01 = highly competitive, 0.15-0.25 ‘moderate concentration’, > 0.25 ‘high concentration’
Reducing market dominance
1) Antitrust laws: making monopolies more competitive by acting against cartels, restrictive business practices, banning anti-competitive pricing strategies, competition restricting behaviours, monitoring acquisitions and joint ventures
2) Regulate behaviour
- P = MC would cause firms to incur a loss, requiring a subsidy, but also DWL as it is financed through a tax, firm also has no incentive to reduce costs
- Higher price than MC equal to ATC to allow firm to earn 0 economic profit
3) Public ownership: Nationalising private monopolies under the government, but private monopolies would usually keep costs as low as they can to maximise profits
4) Fines and criminal charges
