Chapter 16: Monopoly and Market Power: Structure, Pricing, and Welfare in Macroeconomics

Monopoly / Market Power

Introduction to Market Power and Monopoly

Market power refers to a firm's ability to influence the price of its product, rather than being a passive price taker. Monopoly is an extreme case of market power, where a single firm dominates the market.

• Monopoly: A market with only one seller; the firm faces the entire market demand curve.

• Market Power: The ability to charge prices above marginal cost without losing all customers.

• Perfect Competition: Many buyers and sellers, identical goods, no market power, firms are price takers.

Demand Curves: Firm Level vs. Market Level

Firm Demand Curve vs. Market Demand Curve

The demand curve for an individual firm differs from the market demand curve, especially in imperfect competition.

• Firm Demand Curve: Shows the quantity a single firm will sell at different prices.

• Market Demand Curve: Shows total quantity demanded across all firms at each price.

• In perfect competition, the firm's demand curve is perfectly elastic: $MR = P$.

Market Structures and Their Impact on Market Power

Types of Market Structures

Market structure determines the degree of market power a firm possesses.

• Perfect Competition: Many firms, identical products, no market power.

• Monopoly: One firm, unique product, maximum market power.

• Oligopoly: Few large sellers, products may be similar or differentiated, strategic interactions.

• Monopolistic Competition: Many sellers, differentiated products, some market power.

Market Power Continuum

Market power increases as the number of competitors decreases and product differentiation increases.

• Perfect competition: Least market power.

• Monopoly: Most market power.

• Imperfect competition (oligopoly, monopolistic competition): Intermediate market power.

Your Firm's Market Power

Determinants of Market Power

A firm's market power depends on the competitive environment and product differentiation.

• Few competitors: Greater market power.

• Product differentiation: Real (quality, location) or imagined (advertising) differences increase market power.

Profit Maximization with Market Power

Setting Prices and Quantities

Firms with market power face a trade-off between price and quantity sold.

• Higher price increases profit per unit but reduces quantity sold.

• Firm's demand curve: Summarizes how quantity demanded changes with price.

Discovering the Demand Curve

• Experiment with different prices and observe quantities sold.

• Survey customers, vary prices over time, locations, or customer groups.

Marginal Revenue and Profit Maximization

Marginal revenue (MR) is the additional revenue from selling one more unit. Firms maximize profit where $MR = MC$ (marginal cost).

• Output effect: Selling one more unit increases revenue by the price of that unit.

• Discount effect: To sell more, the firm may need to lower the price on all units sold.

• For perfect competition: $MR = P$.

• For monopoly/market power: $MR < P$ due to the discount effect.

Example Table: JJ's Hairdo Revenue

Q	P	TR	MR
0	$60	0	-
1	$55	55	55
2	$50	100	45
3	$45	135	35
4	$40	160	25
5	$35	175	15
6	$30	180	5
7	$25	175	-5
8	$20	160	-15
9	$15	135	-25
10	$10	100	-35

Additional info: Marginal revenue declines faster than price due to the discount effect.

Comparing Market Power and Perfect Competition

Key Differences and Similarities

	Competition	Market Power
Goal of firms	Maximize profits	Maximize profits
Rule for maximizing	$MR = MC$	$MR = MC$
Economic profits in LR?	0	Can be <=> 0
Number of firms	Many	One
Marginal revenue	$MR = P$	$MR < P$
Price	$P = MC$	$P > MC$
Welfare-maximizing output?	Yes	No (less)

Welfare Effects of Market Power

Deadweight Loss and Surplus

Market power leads to higher prices and lower quantities than perfect competition, resulting in deadweight loss (DWL).

• Competitive equilibrium: $P = MC$, total surplus maximized.

• Market power equilibrium: $P > MR = MC$, quantity too low, DWL created.

Deadweight Loss Formula:

• Occurs when $Q_M < Q_C$ and $P_M > MC$.

Barriers to Entry and Long-Run Profitability

Types of Barriers to Entry

• Monopoly resources: Single firm owns a key resource (e.g., DeBeers diamonds).

• Government regulation: Patents, copyrights, exclusive rights.

• Natural monopoly: Economies of scale make one firm most efficient (e.g., utilities).

Short Run vs Long Run

• Short run: Number of competitors is fixed.

• Long run: Entry and exit of firms can occur, affecting market power and profitability.

Entry and Exit Decisions

• Enter if accounting profits > implicit costs (i.e., economic profit > 0).

• Exit if implicit costs > accounting profits (i.e., economic profit < 0).

Firm's Profit Formula:

• $ext{Profit} = (P - ATC) imes Q$

Effect of Entry and Exit on Market Power

Impact of New Competitors

• Decreased demand for incumbents.

• Reduced market power; demand curve becomes flatter.

Impact of Exit

• Increased demand for remaining firms.

• Greater market power for incumbents.

Summary Table: Market Structure and Market Power

Market Type	Firms	Products	Market Power
Perfect Competition	Many	Identical	None
Monopolistic Competition	Many	Differentiated	Some
Oligopoly	Few	Similar/Differentiated	Some
Monopoly	One	Unique	Maximum

Public Policy Toward Monopolies

Antitrust Laws

• Sherman Antitrust Act (1890), Clayton Antitrust Act (1914).

• Prevent mergers, break up companies, stop collusion.

Regulation of Natural Monopolies

• Set prices to maximize surplus (often at $P = MC$).

• May require subsidies if $MC < ATC$ at all output levels.

Examples of Market Power

• HIV drugs: Price far exceeds marginal cost.

• Daraprim: Price increased dramatically due to monopoly power.

• Prison phone calls: Exclusive contracts yield high prices.

Key Formulas

• Marginal Revenue (MR): $MR = \frac{\Delta TR}{\Delta Q}$

• Profit Maximization: $MR = MC$

• Firm's Profit: $\text{Profit} = (P - ATC) \times Q$