Chapter 13

Market Power

Market Structure Continuum

Pure

Competition

Pure

Monopoly

Monopolistic

Competition

Oligopoly

Markets and the Competitive Environment

Economists identify four market types:

• Pure Competition
• Monopolistic Competition
• Oligopoly
• Monopoly

Markets and the Competitive Environment

Perfect competition is a market structure with

• Many firms
• Each sells an identical product (commodity)
• Many buyers
• No restrictions on entry of new firms to the industry
• Both firms and buyers are all well informed about the prices and products of all firms in the industry
• Also referred to as pure competition.

Markets and the Competitive Environment

Monopolistic competition is a market structure with

• Many firms
• Each firm produces similar but slightly different products—called product differentiation
• Each firm possesses an element of market power
• No restrictions on entry of new firms to the industry

Markets and the Competitive Environment

Oligopoly is a market structure in which

• A small number of firms compete.
• The firms might produce almost identical products or differentiated products.
• Barriers to entry limit entry into the market.

Markets and the Competitive Environment

Monopoly is a market structure in which

• One firm produces the entire output of the industry.
• There are no close substitutes for the product.
• There are barriers to entry that protect the firm from competition by entering firms.

Suppose you inherited 100 shares of stock in a large well-known company.

100 shares may seem like a lot, but it is just a small proportion of the number of shares outstanding.

You would like to sell some of the shares, so you visit a broker.

• How do you (or the broker) determine the market price of the stock?
• How much of your stock would you sell if you charged more than the market price of the stock?
• Could you impact the stock price if you sold all 100 shares?
• Would you ever consider charging less than the stock’s market price?

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Perfect Competition

• Market structure in which seller cannot influence price
• Protects consumers from potentially unreasonable prices and prohibits any supplier from having market power
• Market power is defined as the ability of individual firm to influence market price of its product
• Competitive market has three characteristics:
1. Many small buyers and sellers
2. Standardized product (perfect competition)
3. No barriers to entry or exit
• Important implication of characteristics is that competitive firm will be a price taker

Figure 13-1: A competitive market for fresh fish

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The competitive market determines the price per unit of fish. Equilibrium price is $120 per unit (hundredweight), and equilibrium quantity is 7,000 units.

Monopoly

• Market in which only one firm (monopolist) produces product with no close substitutes
• Historical examples:
• Long-distance phone service (AT&T)
• U.S. postal service
• Monopolist is not a price taker but a price maker (firm able to set the market price of its product)
• Does not mean firm will simply set highest possible price; firm can raise price by decreasing quantity it supplies
• Characteristics of monopolies:
1. Single firm
2. Offers for sale a unique product with no close substitutes
3. Market has strong barriers to entry

Figure 13-2: Cable TV demand

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Because the cable TV company’s demand curve is downward sloping, the company simultaneously establishes a price when it supplies a certain quantity. By reducing its output to 20,000 units, it can increase its revenue.

The Soup Nazi

Oligopoly

• Market in which only a few large firms dominate (oligopolists)
• Examples:
• Automobile companies
• Ready-to-eat cereal companies
• Produce large enough share of total market supply of product so that each of these large firms can influence market price
• Firms are interdependent (e.g., Coca-Cola and Pepsi-Cola)
• If oligopoly firms agree to get together and cooperate on output levels, they can set price as high as if they were a monopoly (price fixing illegal in U.S.)

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Concentration Ratio

• Percentage of output produced by four largest firms in an industry (Four Firm concentration ratio)
• If four or fewer firms, concentration ratio will be 100
• If industry contains many small firms, concentration ratio will be very low
• Many economists consider concentration ratio above 60 to indicate tight oligopoly in which firms have significant market power
• Although concentration ratios are useful indicators of possible market power, they are not perfect measures
• Concentration ratios based only on domestic (U.S.) production and exclude foreign competition (e.g., automobiles)
• Many markets are regional (e.g., newspapers and cement)

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Table 13-1: Concentration ratios for selected manufacturing industries, four largest companies, 2013^a

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Barriers to Entry

• Market characteristic that prevents new firms from entering market
• Seven common barriers to entry:
1. Economies of scale
• Large amount of product can be produced at lower cost per unit than small amount of product
• Arise from technology used in manufacturing product, as well as organization of labor (e.g., assembly line) and any discounts that producer may receive on large purchases of inputs

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Barriers to Entry (cont.)

• Exclusive franchises
• Permission by government (often local government) for monopoly firm to exist
• Market with significant economies of scale
• Often case when there is a natural monopoly
• Examples:
• Local telephone companies
• Natural gas companies
• Electric companies

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Barriers to Entry (cont.)

• Control of essential raw materials (nickel, bauxite)
• Patents
• Legal protections that allow inventor to be sole provider of product for period of time
• Government gives patents for new products and new processes to encourage innovation and invention
• Although patents encourage invention, also encourage development of market power:
1. Holder of patent will be sole producer of product for many years
2. Patents can be misused
3. Common practice of aggressively defending patents with patent infringement lawsuits discourages would-be competitors from producing close substitutes

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Barriers to Entry (cont.)

• Product differentiation
• Creation of image (brand name) that one firm’s product is different from or somehow superior to other similar products
• May be real (style, quality, or color) or artificial (created solely by advertising, e.g., Clorox and Bayer Aspirin)
• Licensing
• Government requires new entrants to obtain license (permit) before beginning operation in many professions and trades
• Behavior of established firms
• Price-cutting is example

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Figure 13-3: Output, price, and profits under competition and monopoly

Patented vs. generic drugs; Note that output is lower and that price and profits are higher under a monopoly than they would be under competition.

Collusion

• Better known as price-fixing
• Occurs when firms cooperate to restrict total market output and thereby obtain higher price
• More likely in markets with relatively few firms and substantial entry barriers

Types of Collusion

• Cartel agreements
• Group of producers that has explicit agreement to limit output and charge price higher than competitive price
• Examples:
• Organization of Petroleum Exporting Countries (OPEC)
• DeBeers diamond company
• “electrical equipment conspiracy” (page 325)
• Price leadership
• Occurs in markets in which firms never explicitly agree to collude, but instead somehow come to realization that it is in their best interests to charge similar prices
• One firm emerges as price leader and other firms adjust price whenever leader changes its price
• Firms do not like price competition

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Price Leadership Model

Inefficiency?

• Firms in concentrated markets tend to have less incentive to be efficient than do firms in competitive markets
• A competitive firm must minimize the cost of its product in order to survive, but a firm in a concentrated market protected by entry barriers has no such incentive or less incentive to minimize costs.
• What firms do research and development?
• Tradeoff of economies of scale and market power

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Inverted U Theory of R & D

R&D Expenditure as a Percentage of Sales

Concentration Ratio (Percent)

More Competition

Less Competition

A “loose” oligopoly supports the optimum R&D spending

0 25 50 75 100

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Price Discrimination

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What is it?

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A. A Parable about Pricing

1. Example: Readalot Publishing Company

2. The firm pays an author $2 million for the right to publish a book. (Assume that the cost of printing the book is zero.)

3. The firm knows that there are two types of readers.

a. There are 100,000 die-hard fans of the author willing to pay up to $30 for the book.

b. There are 400,000 other readers who are willing to pay up to $5 for the book.

4. How should the firm set its price?

B. A Parable about Pricing

1. Example: Readalot Publishing Company

2. The firm pays an author $2 million for the right to publish a book. (Assume that the cost of printing the book is zero.)

3. The firm knows that there are two types of readers.

a. There are 100,000 die-hard fans (living in Australia) of the author willing to pay up to $30 for the book.

b. There are 400,000 other readers (living in the United States) who are willing to pay up to $5 for the book.

4. How should the firm set its price?

3. The Moral of the Story

1. By charging different prices to different customers, a monopoly firm can increase its profit.

2. To price discriminate, a firm must be able to separate customers by their willingness to pay.

3. Arbitrage (the process of buying a good in one market at a low price and then selling it in another market at a higher price) will limit a monopolist's ability to price discriminate.

4. Price discrimination can increase economic welfare.

Price Discrimination

• Charging different groups of buyers different prices when price differentials are not justified by differences in costs
• Only possible when firms have significant price-making power
• Extremely common in United States
• Function of price elasticities
• Examples:
• Automobile companies charging different prices for different models of cars
• Drug industry charging different prices for drugs consumed by hospital patients rather than by retail buyers
• Many others (restaurants, movies, airlines, coupons, etc.)
• Student and senior citizen discounts

Price Discrimination

Market Power and Elasticity

• Price discrimination in airline travel
• One group – elastic demand (vacation travelers)
• Lower price
• Higher increase in quantity
• Higher revenue
• The other group – inelastic demand (business travelers)
• Higher price
• Lower decrease in quantity
• Higher revenue

Price Discrimination

The airlines have perfected price discrimination.

Forces That Decrease Market Power

1. Technological change
2. Antitrust activity
3. Deregulation of unwisely regulated sectors
4. Import competition

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1. Technological Change

• Economies of scale often eroded by forces of technological change
• Examples:
• Phone industry
• Railroads

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2. The U.S. Antitrust System

• Set of weapons designed to combat market power
• Consists of laws passed by Congress, agencies empowered to administer laws, and court system to try cases under laws
• Trust: a combination of corporations having a monopoly or near monopoly on the production or distribution of a particular good or service
• Examples of federal antitrust laws:
• Sherman Act (1890)
• Clayton Act (1914)
• Celler-Kefauver Act (1950)

The U.S. Antitrust System

• Principal agencies charged with administering law are Antitrust Division of Justice Department and Federal Trade Commission (FTC)
• Presidential administrations
• Reagan, Bush II: very little antitrust activity
• Bush I, Clinton, Obama: somewhat more active
• Examples of antitrust cases:
• Ticketmaster (1993)
• McDonnell Douglas and Boeing (1997)
• Sprint and WorldCom (2000)
• Microsoft (2000)

3. Regulation and Deregulation

• Natural monopolies that exhibit substantial economies of scale are generally regulated by state or federal government agencies
• Regulation involves limitation of market entry by granting exclusive franchises to firms
• Natural monopoly is regulated with respect to rates charged and level of service offered
• Major problem with regulation occurs when public utility-type of regulation is imposed on industries that are not natural monopolies (e.g., trucking)
• Regulation can shelter firms from competition and actually causes inefficiency (e.g. railroads)
• Deregulation simply means lessening regulatory restrictions

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Regulated Monopoly

Monopoly

price

Fair-return

price

Socially

optimal

price

P_r

D

r

f

b

a

P_f

P_m

Q_m

Q_f

Q_r

MR

MC

ATC

LO7

Regulation and Deregulation

Regulation and Deregulation

Regulation and Deregulation

Regulation and Deregulation

4. Import Competition

• Import quotas and tariffs that limit competition from foreign imports are often called upon to protect American firms
• Powerful firms that lobby Congress to limit imports are often in concentrated markets
• Restricting imports protects market power in concentrated industries, but does not benefit American worker or consumers
• By protecting market power in concentrated industries, ultimately cause lower output levels, lower employment, and higher prices to consumers

Local Aspects of Market Power

• Walmart
• World’s largest privately owned company
• Employs millions of workers
• Profits—tens of billions of dollars
• Supporting arguments
• Low prices—benefit consumers
• Enhances competition
• Increased traffic—increase the business of downtown merchants

Local Aspects of Market Power

• Critics of Walmart
• Unethical business practices
• Wages too low; no unions
• Inadequate health insurance; discrimination
• Global sweatshops
• Foreign workers—lower wages, long hours, less safety, lower environmental regulations
• Prices too low
• Drive local establishments out of business

Too Big to Fail?

• U.S. auto industry
• Concentration ratio = 71
• Considerable market power for
• General Motors, Ford, Chrysler
• Prior to 2008 recession, they were producing mostly pickup trucks and large sport utility vehicles (SUVs)
• High demand and high profit margins
• Union workers: higher salaries, benefits, health care, and pensions

Too Big to Fail?

• The “automobile crisis”
• Triggered by
• Rising energy prices since 2001
• Less competitive than foreign contenders
• Poor business practices
• Subprime mortgage crisis and financial crisis
• By 2009, global economic slowdown
• Decline in car sales

Too Big to Fail?

• The “automobile crisis”
• Fewer consumers purchased automobiles
• Reduced production
• Major lay-offs
• By 2009, Chrysler and General Motors had filed for bankruptcy
• Government – bailed out Chrysler and General Motors and extending a line of credit to Ford
• Government took over restructuring
• GM eliminated some of its models (Pontiac and Oldsmobile)
• Chrysler forced to partner with Fiat

The Economic Left and the Economic Right

THE ECONOMIC RIGHT (Conservative)

• Feel market power is seldom serious problem
• Believe barriers to entry are seldom so high as to eliminate threat of competition from new firms entering industry
• Believe technological change erodes established monopoly positions
• Seldom see need for antitrust or economic regulation, and believe such policies create inefficiency
• Argue that any increased market power created when firms merge is controlled by potential competition from new entrants into industry and by technological change
• Argue that government actually creates monopoly power by granting utility companies exclusive franchises

THE ECONOMIC LEFT (Liberal)

• Believe competition creates efficiency, and government must act to reduce market power that impedes competition
• Support antitrust policy and government regulatory authority
• Feel antitrust system is needed to control excessive market power and that proposed mergers should be scrutinized closely before allowed to take place
• Believe public utilities should be regulated to protect consumer from monopolistic excesses