Market Power (+ Externalities)

Question 1

Monopolies: pros and cons

Answer 1

Pros - infrastructure industries; companies can invest in research

Cons - less choice and higher price for consumers

Question 2

four principal models of market structure

Answer 2

perfect competition many producers each sell an identical product

monopoly - a single producer sells a single, undifferentiated product,

oligopoly - a few producers—more than one but not a large number—sell products that may be either identical or differentiated

monopolistic competition - many producers each sell a differentiated product

This system of market structures is based on two dimensions: 1)The number of producers in the market (one, few, or many) 2) Whether the goods offered are identical or differentiated

Question 3

monopolist/monopoly

Answer 3

A monopolist is a firm that is the only producer of a good that has no close substitutes. E.g. pharmaceuticals

An industry controlled by a monopolist is known as a monopoly.

Question 4

Reasons for monopolies (5)

Answer 4

1) network externalities
2) government-created barriers
3) technological superiority
4) increasing returns to scale
5) control of a (fake) scarce resource or input

Question 5

What do monopolists usually do?

Answer 5

A monopolist reduces quantity supplied and moves up the demand curve raising the price. A monopolist is able to continue earning economic profits in the long run.

Question 6

market power

Answer 6

The ability of a monopolist to raise its price above the competitive level by reducing output

Question 7

Increasing returns to scale

Answer 7

when the output increases in a greater proportion than the increase in input.

Decreasing returns to scale is when all production variables are increased by a certain percentage resulting in a less-than-proportional increase in output.

Question 8

natural monopoly

Answer 8

when increasing returns to scale provide a large cost advantage to a single firm that produces all of an industry’s output.

Question 9

To earn economic profits, a monopolist (1+5)

Answer 9

must be protected by a barrier to entry—something that prevents other firms from entering the industry:

1) Control of a Scarce Resource or Input - A monopolist that controls a resource or input crucial to an industry can prevent other firms from entering its market. Debeers produced most of the world’s diamonds.
2) Increasing Returns to Scale - Local gas supply is an industry in which average total cost falls as output increases. For the same reason, established companies have a cost advantage over any potential entrant—a potent barrier to entry. So increasing returns to scale can both give rise to and sustain monopoly. The source of this condition is large fixed costs: when large fixed costs are required to operate, a given quantity of output is produced at lower average total cost by one large firm than by two or more smaller firms.
3) Technological Superiority - A firm that maintains a consistent technological advantage over potential competitors can establish itself as a monopolist
4) Network Externality - As we learned in Chapter 6, this phenomenon, whereby the value of a good or service to an individual is greater when many others use the same good or service, is called a network externality—its value derives from enabling its users to participate in a network of other users. When a network externality exists, the firm with the largest network of customers using its product has an advantage in attracting new customers, one that may allow it to become a monopolist.
5) Government - Created Barrier - That’s because the U.S. government had given Merck the sole legal right to produce the drug in the United States.

Question 10

A patent

Answer 10

gives an inventor a temporary monopoly in the use or sale of an invention.

Question 11

A copyright

Answer 11

gives the creator of a literary or artistic work sole rights to profit from that work. If inventors are not protected by patents, they would gain little reward from their efforts: as soon as a valuable invention was made public, others would copy it and sell products based on it.

Question 12

Demand curves of a perfectly competitive producer and a monopolist

Answer 12

1) Market price PCP —————–
2) Demand curve of a monopolist \ demand curve is downwards sloping because the supplier has to target all of the consumers

Question 13

Why is the marginal revenue from that 10th diamond less than the price?

Answer 13

It is less than the price because an increase in production by a monopolist has two opposing effects on revenue: 1. A quantity effect. One more unit is sold, increasing total revenue by the price at which the unit is sold. 2. A price effect. In order to sell the last unit, the monopolist must cut the market price on all units sold. This decreases total revenue.

Question 14

the price effect

Answer 14

a monopolist’s marginal revenue from selling an additional unit is always less than the price the monopolist receives for the previous unit. It is the price effect that creates the wedge between the monopolist’s marginal revenue curve and the demand curve: in order to sell an additional diamond, De Beers must cut the market price on all units sold.

Question 15

Monopoly profit: graph

Monopoly markup:

Answer 15

1) notes + as we can see, the demand curve position affects the area of the square –> the revenue. What factors affect this? - consumer willingness to pay, price elasticity
2) The difference between price and marginal cost. The difference in the cost of making the product and the price the monopolist can set for the product. Monopoly markup times products sold is the revenue.

Question 16

to maximize profit, monopolist

Answer 16

compares marginal cost with marginal revenue. If marginal revenue exceeds marginal cost, De Beers increases profit by producing more; if marginal revenue is less than marginal cost, De Beers increases profit by producing less.

Question 17

monopoly’s deadweight loss: graph

Answer 17

quantity QM is lower compared to a competitive market​

price PM is higher compared to a competitive market​

this results in deadweight loss

Question 18

Monopoly’s profit: graph

Answer 18

Figure 8-7

Question 19

oligopoly

Answer 19

an industry with only a small number of producers. When a few firms have a large majority of the market share.

What matters isn’t size per se; the question is how many competitors there are. When a small town has only two grocery stores, grocery service there is just as much an oligopoly as air shuttle service between New York and Washington.

Question 20

source of oligopoly

Answer 20

existence of increasing returns to scale, which give bigger producers a cost advantage over smaller ones. When these effects are very strong, they lead to monopoly; when they are not that strong, they lead to an industry with a small number of firms. For example, larger grocery stores typically have lower costs than smaller ones. But the advantages of large scale taper off once grocery stores are reasonably large, which is why two or three stores often survive in small towns.

Question 21

collusion; cartel

Answer 21

Sellers engage in collusion when they cooperate to raise their joint profits.

A cartel is an agreement among several producers to obey output restrictions in order to increase their joint profits. This determines how much each them will produce. Also sometimes governments.

Question 22

Why do individual firms have an incentive to produce more than the quantity that maximizes their joint profits?

Answer 22

Because neither firm has as strong an incentive to limit its output as a true monopolist would. . In the case of oligopoly, when considering the effect of increasing production, a firm is concerned only with the price effect on its own units of output, not those of its fellow oligopolists. This tells us that an individual firm in an oligopolistic industry faces a smaller price effect from an additional unit of output than does a monopolist; therefore, the marginal revenue that such a firm calculates is higher. So it will seem to be profitable for any one company in an oligopoly to increase production, even if that increase reduces the profits of the industry as a whole. But if everyone thinks that way, the result is that everyone earns a lower profit!

Question 23

How does a monopoly increase inefficiency? graph

Answer 23

Figure 8-8

Question 24

if the monopolist can perfectly price discriminate, then marginal revenue is equal to

Answer 24

the demand curve in a perfect discrimination cuz they charge each customer at their willingness to pay

Question 25

monopsony

Answer 25

A monopsony exists when there is only one buyer of a good. A monopsonist is a firm that is the sole buyer in the market.

Question 26

public ownership

Answer 26

In public ownership of a monopoly, the good is supplied by the government or by a firm owned by the government. Instead of allowing a private monopolist to control an industry, the government establishes a public agency to provide the good and protect consumers’ interests

Question 27

Price regulation

Answer 27

limits the price that a monopolist is allowed to charge. Not necessarily: a price ceiling on a monopolist need not create a shortage—in the absence of a price ceiling, a monopolist would charge a price that is higher than its marginal cost of production. So even if forced to charge a lower price—as long as that price is above MC and the monopolist at least breaks even on total output—the monopolist still has an incentive to produce the quantity demanded at that price.

Question 28

Breaking up a monopoly that isn’t natural is clearly a good idea:

Answer 28

the gains to consumers outweigh the loss to the producer. But it’s not so clear whether a natural monopoly, one in which a large producer has lower average total costs than small producers, should be broken up, because this would raise average total cost. For example, a town government that tried to prevent a single company from dominating local gas supply—which, as we’ve discussed, is almost surely a natural monopoly—would raise the cost of providing gas to its residents.

Question 29

Antitrust policy/laws

Answer 29

consists of efforts undertaken by the government to prevent oligopolistic industries from becoming or behaving like monopolies.

Question 30

A price war

Answer 30

occurs when tacit collusion breaks down and prices collapse. Because tacit collusion is often hard to achieve, most oligopolies charge prices that are well below what the same industry would charge if it were controlled by a monopolist—or what they would charge if they were able to collude explicitly. In addition, sometimes collusion breaks down and there is a price war. A price war sometimes involves simply a collapse of prices to their noncooperative level. Sometimes they even go below that level, as sellers try to put each other out of business or at least punish what they regard as cheating.

Question 31

Differentiated products -

Answer 31

The key to product differentiation is that consumers have different preferences and are willing to pay somewhat more to satisfy those preferences. Each producer can carve out a market niche by producing something that caters to the particular preferences of some group of consumers better than the products of other firms. There are three important forms of product differentiation: differentiation by style or type, differentiation by location, and differentiation by quality.

Question 32

The monopolist’s decision:

Answer 32

good news - a monopolist maximizes profit like every other firm​
that is: MR = MC​

bad news - the quantity a monopolist produces also affects the marginal revenue​

that is: MR ̸= P​ in fact:​ MR < P​ —->\

Question 33

A Monopolist’s Marginal Revenue: graph

Answer 33

Quantity Effect: ​one more unit sold increases total revenue by the price at which it is sold​

Price Effect: ​to sell an additional unit the monopolist must cut the price on all units sold resulting in decreasing total revenue​

Question 34

What Should Governments Do to Solve the Trade-off?

Answer 34

patent buyouts​: a government could buy a patent for a little more than the monopoly profit, then rip it up​
+ competitors could enter and drive price to MC​
higher taxes (also come with deadweight loss)​
difficult to determine the price in advance​

prizes

Question 35

external cost: graph (4)

Answer 35

producers do not internalize the true cost of production

result: quantity supplied is too high QM > QE

adding external cost → shift of supply curve

potential solution: Pigouvian tax

Question 36

External Benefit: graph (4)

Answer 36

consumers do not internalize the true benefits
result: demanded quantity is too low QM < QE
adding external benefits → shift of demand curve • potential solution: Pigouvian subsidy

Question 37

Transaction Costs

Answer 37

Transaction costs are all the costs
necessary for buyers and sellers
to reach an agreement, e.g. the
costs to measure the external
benefit.

Question 38

The Coase Theorem

Answer 38

If transaction costs are low and property rights are
clearly defined, private bargains will ensure that the
market equilibrium is efficient even if there are
externalities.

but the theorem suggests an alternative approach to deal with externalities: the creation of new markets!
• If this new market can
▶ define property rights
▶ reduce transaction costs
• then this market can be used to deal with problems created by externalities
• Tradable Pollution Permits

Question 39

Like a firm in a competitive market, the monopolist sets marginal revenue equal to marginal
cost to maximize profit. However, equilibrium output and price in a monopolistic market are
different compared to a competitive market. How are equilibrium output and price different?
Explain why this is the case

Answer 39

output is less, price is higher. MC=MR has to take into account two effects. By increasing quantity monopoly has to decrease the price.

Question 40

A monopoly is less efficient than a competitive market. Explain why

Answer 40

Deadweight loss because the quantity is lower than efficient market quantity and the price is larger

Question 41

A monopolist can sometimes offer different prices to different consumers. The pharmaceutical
company decides to offer its novel treatment at lower prices in low-income countries than in
high-income countries. What happens to the monopolist’s profit in this case? Are two different
prices more or less efficient than one?

Answer 41

price discrimination occurs: the monopoly seller of a good or service must know the absolute maximum price that every consumer is willing to pay and can charge each customer that exact amount. This allows the seller to obtain the highest revenue possible.

Question 42

The government - concerned by the high price of the treatment - considers to step in and break
up the monopoly. Describe what trade-off a government has to make when making such a
decision? What is a possible alternative?

Answer 42

the trade-off between efficiency and incentives for innovation. Breaking the monopoly would decrease the price and increase the quantity. However, without a monopoly, there might be less incentives for companies to innovate in the future because it is not profitable.