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Extra Reading • Product Differentiation Download
Market Power • Market power is the ability of a firm to affect the market price of a good to their advantage. In declining order. • Monopoly – A single producer without competition • Monopolistic Competition – Firms selling differentiated products.
Price effects • There is a demand curve relating the quantity of a product that can be sold at a given price. • Invert the concept: For each quantity, there is a price that the market may bare. • Change the quantity and change that price • Marginal revenue
Marginal Revenue • For price taking firm, marginal revenue is equal to price. • For a firm with market power, marginal revenue must include the change in the price that results from a change in quantity.
Theoretical Note: Monopolies and Inelastic Demand • Monopolist will not operate where demand elasticity is between 0 and -1. Why? • Raising prices/cutting production will increase revenues. MR < 0 • When facing an inelastic demand, monopolist raises prices until demand becomes inelastic.
Example Demand MR
Monopolist • Maximize Profits by choosing an output level such that marginal revenue equals marginal cost. • Price will exceed marginal cost. Monopolists will make greater profits than a competitive firm. • Monopolists will charge higher prices and produce less output than a competitive industry. • Profits should attract new entrants to the market. • Monopoly can only survive if there are some barriers to entry.
Monopolist: Constant Cost Price P* MC = ATC D MR Output QMono QPC
Monopolist: Revenue Price P* Revenues MC = ATC D MR Output Q*
Monopolist: Profits Price P* Profit MC = ATC D MR ATC Output Q*
Monopolist: General Case MC Price ATC P* D MR Output Q*
Monopolist: Revenue MC Price ATC P* Revenues D MR Output Q*
Monopolist: Costs MC Price ATC P* D Costs MR Output Q*
Monopolist: Profits MC Price ATC P* Profits D MR Output Q*
Markups • If a market is competitive, then price will equal marginal cost. • Degree of market power is often measured as markup over marginal cost
Rule of thumb for a monopolist, • If markups are below this level, raise prices. • If markups are above this level, lower prices.
Monopolist’s Schedule • The less elastic the demand curve, the higher the market power. • The greater the market power, the greater the markup. • Firm has more pricing power if good has fewer substitutes. .
Barriers to Entry • Total Control over Vital Resource • Alcoa in the aluminum market • DeBeers in Diamond market • Patents or Secret Formula: • Xerox: Controlled photocopying • Regulations: Jockey Club, SDTM • Gambling is a legally restricted monopoly • Returns to Scale: • TownGas is an regulated monopoly supplier of a particular type of piped natural gas (may have competition from LNG)
Monopolistic Competition • Most firms produce a good that is (to a certain extent) unique. No other good has the exact same properties. • Coke, Pepsi, President’s Choice • To the extent that you are a unique producer, you will have some market power. • Products may vary by type, scale, or location.
Characteristics of Monopolistically Competitive Markets • Differentiated Products • Free Entry into very similar markets. • Fixed costs of setting up production • Individual firms face downward sloping demand curve and a falling average total cost curve. • They would sell more if they could at the going rate but lowering their prices to sell more would lead to losses.
No Barriers to Entry • What happens if new firms can enter? • If there are profits to be had, entrepreneurs will enter markets to provide close substitutes for profit making goods. • New goods splitting the market and better substitutes means lower, flatter demand curve.
Profitable Monopolistic Competition:Short-term Price MC ATC P* D MR Output Q*
Unprofitable Monopolistic Competition:Short-term Price MC ATC P* D MR Output Q*
Monopolistic Competition:Entry of Competitors MC Price ATC D D′ MR MR′ Output Q*
Monopolistic Competition:Long-term Price MC ATC P* D MR Output Q*
Monopolistic Competition vs. Perfect Competition • Similar: Both have many firms, both have zero profits and P = ATC. • Different: • P > MC : On the margin, monopolistically competitive firms want more customers. Greater variety generated by this market may compensate for loss of efficiency. • MC < ATC: Firm is operating at a level that does not minimize total costs.
Variety and Monopolistic Competition • Given that most markets have the “feel” of monopolistic competition, do we have too many firms or is variety it’s own reward? • Does advertising create phony differentiation or provide information?
Monopolistic Competition and Entrepreneurship • New markets are frequently developed. • For many goods, the only barriers to entry is imagination. • Entrepreneurs develop new ideas for new goods. The pay-off for entrepreneurship are short-run monopoly profits. (Ted Turner and CNN). Only in rare cases will firms be able to make long-term monopolistic profits.
Learning Outcomes • Define marginal revenue. • Characterize the relationship between price, marginal revenue, marginal cost, average total cost, and profits in a monopolistic market. • Use the rule of thumb to calculate optimal markups. • Describe 4 barriers to entry that may enable monopoly power. • Characterize the relationship between price, marginal revenue, marginal cost, average total cost, and profits in a monopolistically competiive market.
Closed Book Final • Date: Sunday, October 28th • Time: 2:00-5:00 • Place: Room 3007, 3008 • Coverage: Material in Notes to date • Bring Calculator, Writing Instruments • Good Luck!