Lecture 7

Markets with market power

(Please note that there is no Part II of Lecture 6)

Four idealized types of market

structure

• Perfect competition: many sellers; they are selling an identical product

• Pure monopoly: only one seller

• Monopolistic competition: many sellers, selling slightly different goods/services

• Oligopoly: only a few sellers; each needs to watch what the others are doing

Pure monopoly

• Conditions:

– There is only one seller

– The good has no close substitutes

– Barriers to entry prevent other firms from starting to produce the good

• Barriers to entry: economic, legal, or deliberate obstacles that keep new sellers from entering a market

Pure monopoly: Barriers to entry

• Economic barriers: related with the production technology (high fixed costs, economies of scale, network externalities. Ex: natural monopoly)

• Legal barriers: copy rights, franchises, patents, trademarks

• Deliberate barriers: physical, financial, and political intimidation of potential competitors. Many are illegal (Ex: predatory pricing, dumping, exclusionary practices)

Pure monopoly: Profit maximizationMarginal Revenue for a Monopolist

Quantity of

Output

Selling Price

($)

Total Revenue

($)

Marginal Revenue

($)

1 44 44 44

2 40 80 36

3 36 108 28

4 32 128 20

5 28 140 12

6 24 144 4

7 20 140 4

8 16 128 12

9 12 108 20

Pure monopoly: Profit maximization

Pure monopoly and inefficiency

Can monopoly be efficient?

In some cases, the efficiency cost of monopoly may not be as bad as the previous analysis suggests:

• Natural monopoly: A single big firm may sometimes be socially preferable compared to many small ones.

• Intellectual property: Firms may need a period of exclusive, high profits in order to cover the costs of research and development

• When there is some pressure to appear competitive, monopolies may tend to reduce the price and increase the quantity that it produces

• Perfect price discrimination: A monopolist able to charge different prices to its customers based on their willingness to pay would be efficient.

Can monopoly be efficient?

Price discrimination: A seller charging different prices to different buyers, depending on their ability and willingness to pay

Perfectly price discriminating monopolist: an extreme form of price discrimination

Monopolistic competition

• Conditions:

– Many sellers and buyers

– The sellers produce slightly different products (product differentiation)

– Sellers can freely enter and exit

– Buyers have perfect information

Monopolistic competition: Profit

maximization

MC

D2

D1

MR1

MR2

Quantity

Pri

ce

Monopolistic competition: Long-run

efficiency

Oligopoly

• Conditions:

– Only a few sellers control the market

– Entry is difficult

• Concentration ratio:

The share of total production, sales, or revenues attributable to the largest firms in an industry (usually the share of the largest four firms)

Examples (from year 2002):

Car and light-truck manufacturing in the US: 88.1%

Breakfast cereal manufacturing: 78.4%

Credit card issuing financial firms: 75.8%

Oligopoly: Behavior of firms

• The behavior of oligopolistic firms is interdependent; marginal thinking that we used so far not applicable anymore

• Therefore, game theory needed to analyze the behavior of oligopolistic firms (due to strategic interaction between firms)

Oligopoly: An example with a DuopolyF

irm

1’s

Options

Low Price High Price

Firm 2’s Options

low profit

low profit

moderate profit

moderate profit

loss

loss

high profit

high profit

High Price

Low Price

Assume that the firms are non-cooperative: They are rivals and do not communicate or cooperate with each other

This payoff matrix shows possible outcomes for each of the two players, depending on the strategy each one chooses

Oligopoly: Collusion, cartels, etc.

• Collusion: Cooperation among potential rivals to gain market power as a group

• Cartel: explicit collusion (Example: OPEC)

• Tacit collusion: collusion that takes place without creation of a cartel (without a formal organization)

• Price leadership: a form of collusion in which many sellers follow the price changes instituted by one particular seller

Oligopoly: Efficiency?

• Inefficient like pure monopoly

• Maybe even worse sometimes:

Because no possibility of reaping advantages of economies of scale

Summary: 4 types of idealized market

structures

Summary of Traditional Market Structures

Perfect

Competition Pure Monopoly

Monopolistic

Competition Oligopoly

Number of

Sellers in the

Market

many one many few

Type of Item(s)

Sold identical unique differentiated varies

Market Power of

an Individual

Seller

none very high some substantial

Entry Barriers none very high none some

Long-Run

Economic Profit zero positive zero varies

Profit-

Maximizing

Condition

MC = P MC = MR MC = MR varies