Theme 6 - Monopoly and Market Power

Question 1

What are the characteristics of the economic environment for a monopoly?

Answer 1

1. Only one firm/supplier and a large number of buyers
2. Lack of substitute products
3. Barriers to entry (obstacle that limits the possibility of firms to enter on the market)

Question 2

What are the sources of market power?

Answer 2

Economic barriers
- Cost advantages (Control of an inout/ressource, specific technology)
- Economies of scale (high fixed costs is a barrier to entry as the firm benefits from economies of scale)
- Network externalities (good for which the value goes up when there is a high number of users (ex.: facebook))

Legal barriers
- Government regulation (license or permits)
- Patents and copyrights to protect discoveries or inventions

Question 3

Compare the demand curve in perfect competition vs in a monopoly

Answer 3

In perfect competition, the demand is perfectly elastic (horizontal)

For a monopoly, the demand curve is decreasing just like the MR curve, which reflects the trade-off the monopolist faces (sell more at a lower P or sell less at a higher P)

Question 4

How can the monopolist’s marginal revenue be expressed with Ep? (formula) What can it tell us?

Answer 4

MR = P [ 1 + 1/Ep ]

The monopolist will always produce in the elastic portion of the demand curve because when Ep = -1 (unit elastic), MR = 0 and the MR decreases the more inelastic the demand is

Question 5

What is market power? How can we measure it? (formula)

Answer 5

Market power is a firm’s ability to charge a price higher than its MC without loosing all its customers.

The monopoly gets his market power from the absence of perfect substitutes and from barriers to entry.

We can measure market power with the Lerner index
L = (P - MC)/P = [-1 / Ep ]

The larger L is, the larger the market power is

Question 6

What are the characteristics of Monopolistic Competition?

Answer 6

1. Many firms on the market
2. Free entry and exit
3. No firm has complete power on the market price
4. Firms have some market power
5. Firms compete by selling differentiated products that are highly substitutable for one another but not perfect substitutes

Question 7

What is product differentiation?

Answer 7

Product differentiation is the effort by firms to produce goods or services that are superior to those of other firms.

Common types of differentiation are physical characteristics (quality, service, etc.), convenience (location or time) and lifestyle

Advertising is a means to differentiate (a tool)

Product differentiation creates market power

Question 8

Describe firms in a monopolistic competition in the short-run

Answer 8

Short-run: Like a monopoly

Individual firms face a downward-sloping demand curve.
The product differentiation implies market power and P > MC.
Firms may be experiencing positive profits with P > AC.