Market Power: Monopoly and Monopsony (Microeconomics Study Notes)

Market Power: Monopoly and Monopsony

Introduction

This chapter explores how market structure affects the pricing, investment, and output decisions of firms. It focuses on monopoly (one seller), monopsony (one buyer), and the concept of market power—the ability of a seller or buyer to affect the price of a good.

Monopoly

Average Revenue and Marginal Revenue

• Marginal Revenue (MR): The change in total revenue resulting from a one-unit increase in output.

• Average Revenue (AR): Total revenue divided by quantity sold; for a monopolist, AR equals the price.

• Example: For the demand curve $P = 6 - Q$, the following table shows total, marginal, and average revenue:

Price (P)	Quantity (Q)	Total Revenue (TR)	Marginal Revenue (MR)	Average Revenue (AR)
6	0	0	-	-
5	1	5	5	5
4	2	8	3	4
3	3	9	1	3
2	4	8	-1	2

The Monopolist's Output Decision

• Profit Maximization: A monopolist maximizes profit by producing the quantity $Q^*$ where marginal revenue equals marginal cost ($MR = MC$).

• If output is less than $Q^*$, the firm sacrifices profit; if output is more, the additional cost exceeds additional revenue.

• Algebraic Condition: Profit $(Q) = R(Q) - C(Q)$ is maximized when $\frac{d\pi}{dQ} = \frac{dR}{dQ} - \frac{dC}{dQ} = 0$, i.e., $MR = MC$.

Rule of Thumb for Pricing

• Marginal revenue can be expressed as:

$MR = P + Q \frac{dP}{dQ}$

• Since $Q \frac{dP}{dQ}$ is the reciprocal of the elasticity of demand $E_d$, at the profit-maximizing output:

$MR = P + P \left( \frac{1}{E_d} \right)$

• Setting $MR = MC$ gives:

$P = \frac{MC}{1 + \frac{1}{E_d}}$

• This formula shows price as a markup over marginal cost, depending on the elasticity of demand.

Shifts in Demand

• A monopolistic market has no supply curve; there is no one-to-one relationship between price and quantity produced.

• Shifts in demand can lead to changes in price with no change in output, changes in output with no change in price, or changes in both.

• Unlike competitive markets, a monopolist may supply different quantities at the same price or the same quantity at different prices.

The Effect of a Tax

• A specific tax $t$ per unit increases the monopolist's marginal cost to $MC + t$.

• The new profit-maximizing condition is $MR = MC + t$.

• Typically, the increase in price $\Delta P$ is larger than the tax $t$ due to the monopolist's pricing power.

The Multiplant Firm

• If a firm has multiple plants, it should allocate output so that marginal cost is equal in each plant ($MC_1 = MC_2 = ...$).

• Total output should be set so that $MR = MC$ for the firm as a whole.

• Algebraic Condition: $MR = MC_1 = MC_2$

Example: Astra-Merck Prices Prilosec

• Prilosec was priced at $3.50 per daily dose, with marginal cost only $0.30-$0.40.

• Price elasticity of demand was between -1.0 and -1.2.

• Markup exceeded 400% over marginal cost, consistent with the rule of thumb for pricing.

Monopoly Power

Measuring Monopoly Power

• Lerner Index: Measures monopoly power as the excess of price over marginal cost as a fraction of price.

$L = \frac{P - MC}{P}$

• Can also be expressed in terms of elasticity of demand:

$L = -\frac{1}{E_d}$

Elasticity of Demand and Price Markup

• The markup formula:

$P = \frac{MC}{1 + \frac{1}{E_d}}$

• If demand is elastic, markup is small and monopoly power is low.

• If demand is inelastic, markup is large and monopoly power is high.

Example: Elasticities of Demand for Soft Drinks

• Market elasticity for soft drinks: -0.8 to -1.0.

• Brand elasticity (e.g., Coca-Cola): around -5.0.

• Consumers can easily substitute brands, making brand demand more elastic than market demand.

Sources of Monopoly Power

Determinants of Monopoly Power

• Elasticity of Market Demand: The less elastic the market demand, the greater the potential monopoly power.

• Number of Firms: Monopoly power decreases as the number of firms increases; highly concentrated markets have few firms.

• Interaction Among Firms: Aggressive competition reduces monopoly power; collusion increases it.

• Barriers to Entry: Patents, copyrights, licenses, and economies of scale can prevent new competitors from entering the market.

Example: Markup Pricing from Supermarkets to Designer Jeans

• Elasticity of market demand for food is about -1; supermarkets set prices about 11% above marginal cost.

• Convenience stores (elasticity about -5) set prices about 25% above marginal cost.

• Designer jeans (elasticity -2 to -3) set prices 50-100% above marginal cost.

Example: The Pricing of Videos

• As the market for videos matured, prices dropped due to increased elasticity of demand and competition.

Title	Retail Price (VHS)	Retail Price (DVD)
Purple Rain	$24.95	$32.95
Raiders of the Lost Ark	$29.95	$17.99
Star Wars	$39.99	$29.99
The Divergent Series: Allegiant	-	$32.95
The Revenant	-	$17.99

Social Costs of Monopoly Power

Deadweight Loss

• Monopoly leads to higher prices and lower output compared to competitive markets.

• This results in a deadweight loss: a reduction in total surplus (consumer and producer surplus).

• Rent seeking: Firms may spend resources to maintain monopoly power, leading to further inefficiency.

Price Regulation

• Governments may regulate monopolies by setting prices, often at average or marginal cost.

• Price regulation can reduce monopoly power and deadweight loss, but may also cause shortages if prices are set too low.

Monopsony

Definitions and Key Concepts

• Monopsony: Market with only one buyer.

• Oligopsony: Market with only a few buyers.

• Marginal Value: Additional benefit from purchasing one more unit.

• Marginal Expenditure: Additional cost of buying one more unit.

• Average Expenditure: Price paid per unit.

Monopsony Power

• A monopsonist can affect the price it pays by varying the quantity it purchases.

• Monopsony power is greater when the supply curve is inelastic.

• Sources of monopsony power include the elasticity of market supply, the number of buyers, and the interaction among buyers.

Social Costs of Monopsony Power

• Monopsony leads to lower prices and lower quantities purchased compared to competitive markets.

• This results in deadweight loss, reducing total welfare.

Bilateral Monopoly

• Bilateral Monopoly: Market with only one seller and one buyer.

• Price and quantity are determined by bargaining; monopsony and monopoly power tend to counteract each other.

Limiting Market Power: The Antitrust Laws

Antitrust Laws and Enforcement

• Antitrust laws restrict actions that restrain competition, such as collusion and predatory pricing.

• Enforcement occurs through the Department of Justice, Federal Trade Commission, and private proceedings.

• European Union antitrust laws are similar to those in the United States.

Examples of Antitrust Violations

• Price fixing and collusion can result in criminal penalties, including prison terms for executives.

• Merger policy debates focus on balancing cost-saving efficiencies against potential harm to competition.

Summary Table: Monopoly vs. Monopsony

Feature	Monopoly	Monopsony
Market Structure	One seller	One buyer
Market Power	Can set price above MC	Can set price below MV
Social Cost	Deadweight loss (higher price, lower output)	Deadweight loss (lower price, lower quantity purchased)
Regulation	Price regulation, antitrust laws	Rare, but possible in labor markets

Key Formulas

• Profit Maximization: $MR = MC$

• Lerner Index: $L = \frac{P - MC}{P}$

• Monopoly Pricing Rule: $P = \frac{MC}{1 + \frac{1}{E_d}}$

Additional info:

• These notes are based on textbook slides and include expanded academic context for clarity and completeness.