Class 4: Monopoly and Market Power. Power to affect market price or the ability to set price above marginal cost Monopoly power and monopsony power

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1 Class 4: Monooly and Market Power. Market ower Power to affect market rice or the ability to set rice above marginal cost Monooly ower and monosony ower An examle of monosony ower: The big-3 and their ower in urchasing car batteries, tires, and other arts. Cost of market ower on society: Less roduction (i.e., less consumtion) at a higher rice Antitrust laws and rice regulation. Monooly: A sole roducer and many buyers ) Market demand facing a monoolist Downward-sloing demand curve Monoolist s rice = Average revenue D( AR( In a erfectly cometitive market, the demand curve (or average revenue) for a firm is a horizontal line at the level of a given market rice Market rice=average revenue=marginal revenue=market demand line ) Profit-maximizing outut () The rule: MC( q ) MR( q ) () Marginal revenue for a monoolist - When the demand curve (i.e., average revenue) is downward-sloing, the marginal revenue is below the demand curve, which is the average revenue curve for a monoolist

2 - Mathematically: MR( d( TR) dq d( dq ( ) < Examle > With a linear demand a Q b, MR( d( TR) dq d( dq a Q b. (3) Marginal cost (4) The otimal outut MC( MR( ( ) and thus ( MC), the rice cost margin divided by rice or the Lerner Index of monooly ower With a lower rice elasticity, the monooly ower is greater (e.g., OPEC and the oil rice) Since at the otimal outut MC (and MR) is ositive,. (5) Price under erfect cometition and monooly Under erfect cometition, MC Under monooly, MC { ( ) }, which is greater than MC, deending on the magnitude of the rice elasticity of demand; When demand is very rice elastic, there is little benefit to a monoolist. 3. Market suly curve under monooly ) No suly curve No one-to-one relationshi between rice and quantity roduced The monoolist s outut decision deends not only on the marginal cost but also on the shae of the demand curve Under erfect cometition, the market suly curve is the sum of the marginal cost curves for individual firms

3 ) Effect of a tax Under erfect cometition, a tax on an industry () raises the market rice by the amount less than the tax, and () the tax burden is shared by roducers and consumers Under monooly, sometimes, rice can rise by more than the amount of the tax. 4. Some behavioral characteristics of monooly ) A firm with two different lants and the rofit function - Profit function: Q Q ) R( Q Q ) C ( Q ) C ( ) ( Q - Profit-maximization rule for each lant: Q 0 and Q 0 MR( Q Q ) MC ( Q ) MC ( Q ) Show grahically and exlain the outut roduced is determined at the oint where MR MC, where MC is obtained by horizontally summing u MC and MC ) Price discrimination: Charge different rices to different consumer grous - The basis of rice discrimination: consumer surlus and market ower - First-degree rice discrimination: A different rice for each consumer Charging each consumer his/her reservation rice (the maximum rice each consumer is willing to ay for each unit bought) D( AR MR No consumer surlus (all catured by the monoolist) (Ex: Professionals, such as doctors and lawyers, charging different rices to different clients) The lowest rice = the cometitive rice = the rice the last consumer with the lowest reservation rice ays Outut roduced = out roduced under erfect cometition 3

4 - Second-degree rice discrimination Charging different rices for different quantities and blocks of the same good or services - Third-degree rice discrimination Charging different rices to different grous with different demand characteristics Pricing Rule: ( R (, Q ) R (, Q ) C( Q Q ) and rofitmaximizing for each grou Q 0 and Q 0, which results MR MR MC Which grou is charged a higher rice? The grou with a lower rice elasticity MC { ( ) } and MC { ( ) }. Thus, ( )} { ( )} and ) 0 { ( < Examle: The yramid of rice discrimination > X A 05 0, X B 5 50, and MC ) Intertemoral rice discrimination and Peak-load ricing Charging different rices for different time: eak and off-eak < Examle: A restaurant > At the eak time: rice = total marginal cost = fixed marginal cost for sace (i.e., seats) + variable marginal cost for food At the off-eak time: rice = variable marginal cost 4) Two art tariff Form of ricing in which consumers are charged both an entry and a usage fee < Case: Polaroid Cameras on the text > 4

5 5. Sources of monooly ower ) The elasticity of demand Lower rice elasticity and higher monooly ower ) The number of firms (major layers) - Measures of market concentration Concentration ratio ( CR ) The Herfindahl-Hirschman Index: i H n m i i - Barriers to entry: Legal barriers (atents & coyrights) and economies of scale (i.e., natural monooly) 3) Interaction among firms: Rivalry vs. collusion 6. Social costs of monooly ower and regulation ) Changes in consumer surlus, roducer surlus, and social welfare Outcome of monooly ower: Higher rice and low quantity roduced Consumer surlus reduced due to higher rice Producer surlus changed Social welfare reduced by the amount of the deadweight loss from the monooly ower (due to the forgone outut) < Examle: ( X ) 0 0. X and MC. Then,, X and DW? > Rent seeking: A monoolist sends a large amount of money in socially unroductive efforts to acquire, maintain, or exercise its monooly ower (e.g., lobbying activities, advertising, legal efforts to avoid antitrust scrutiny, extra roduction caacity) Social cost of monooly might exceed deadweight loss due to rent seeking behavior 5

6 ) Price regulation (e.g.: Price ceiling) A limited rice under the monooly rice Reduce market rice and greater quantity roduced Reduced deadweight loss due to increased outut < Examle: A rice ceiling on a natural monooly > Natural monooly with diminishing average cost curve due to strong economies of scale (above marginal cost curve) A natural monooly is a firm that can roduce the entire outut of the market at a cost that is lower than what it would be if there were several firms The first best (marginal-cost ricing; negative rofit) and the second-best (average-cost ricing; zero economic rofit) Regulatory Lag: The delay in adjusting regulatory rice to changes in the market conditions (due to the identification roblem of the average cost ricing) 3) Antitrust regulation 6

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