Market Power. Industrial Organization (UG) Spring, Li Zhao, SJTU

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1 Market Power Industrial Organization (UG) Li Zhao, SJTU Spring, 2016

2 Outline Cost Function Prot Maximization Perfect Competition Market Power Monopoly Eciency Market Power: A Second Look

3 Cost Function Cost function C(q): minimum cost of producing a given quantity q. Two inputs, capital and labor. The production function is q = K 1/2 L 1/2. Total cost is TC = K + 4 L + FC. Lagrangian function is O = K + 4K + FC + λ(q 2 KL). We get K = 2q, L = 1 q, C(q) = 4q + FC. 2 Marginal cost MC(q) = dc(q) = 4 is a constant. dq

4 Cost Function - Another Example Let C(q) = q + 5q 2. AC(q) = q. q MC(q) = q. AC rises if MC exceeds it, and falls if MC is below it. Implies that MC intersects AC at the minimum of AC.

5 Economies of Scale AC (q) < 0: increasing returns to scale. AC (q) > 0: decreasing returns to scale. AC (q) = 0: constant returns to scale. A measure of the degree of scale economies: S = AC(q) MC(q). S > 1 implies the presence of scale economies. S > 1 AC (q) 0??

6 Outline Cost Function Prot Maximization Perfect Competition Market Power Monopoly Eciency Market Power: A Second Look

7 Prot Maximization To understand rm behavior we typically start by assuming its objective is to maximize prots, which seems reasonable. π(q) = R(q) C(q). MR(q) = MR(q) MC(q) If MR > MC, the prots of the rm increase as it expands its output. If MR < MC, the prots of the rm will increase if it reduces its output. When MR = MC, the output level of the rm will be prot maximizing.

8 Prot Maximizing The prot-maximizing rule is that a rm should produce at the output level q* that equates marginal revenue and marginal cost. MR(q ) = MC(q ). This is true for both rms that are price-taker (perfect competition) and rms that have market power.

9 Prot Maximizing Actually, MR(q ) = MC(q ) is the prot-maximizing rule only if a rm stays in business. Firms have another decision to makewhether to keep producing or shut down. In the short run... In the long run...

10 Outline Cost Function Prot Maximization Perfect Competition Market Power Monopoly Eciency Market Power: A Second Look

11 Perfect Competition - Features Perfect competition constitutes a market with innite sellers and buyers. Economies of scale are small relative to the size of the market. All sellers bring homogeneous products to the market. Information is perfect. All rms are fully informed about their production possibilities and consumers are fully aware of their alternatives. There are no entry or exit barriers, no transportation cost, etc.

12 Prot-Maximization in Perfect Competition Recall the prot-maximization rule says MR(q) = MC(q). The marginal revenue function of a price-taking rm is MR(q) = P. The prot-maximizing choice for any price-taking rms is Graph in micro class. P = MC(q c ).

13 Examples of Perfect Competition

14 Examples of Perfect Competition Agricultural markets. But, we will watch a video showing how a Dairy company in California tries to dierentiate its product. Foreign exchange markets. But, we see large price dispersion of the retail S&P 500 index funds.

15 Does Perfect Competition Exist in the Real World? Homogenous product? Even with a product as simple as bottled water, for example, producers vary in the methodology of purication, product size, brand identity, etc. No entry cost? Many industries also have signicant barriers to entry, such as high startup costs (as seen in the auto manufacturing industry) or strict government regulations (as seen in the utilities industry) In the real world, companies are constantly engaged in a battle, wanting to outdo their competitors. Innovation? Advertisement?

16 Outline Cost Function Prot Maximization Perfect Competition Market Power Monopoly Eciency Market Power: A Second Look

17 Market Power Recall in perfect competition P = MC(q c ). A rm has market power if it nds it protable to raise price above marginal cost. The ability of a rm to protably raise price above marginal cost depends on the extent to which consumers can substitute to other suppliers. It is possible to distinguish between supply and demand substitutions. Supply side substitution is relevant when products are homogeneous. Demand side substitution is applicable when products are dierentiated.

18 Supply Side Substitution - Artical Sweetener In the early 1980s, the only articial sweetener that didn't appear to cause cancer in rats was aspartame. Other rms were excluded from producing aspartame by the patents of the sole producer, the NutraSweet Company.

19 Supply Side Substitition - OPEC

20 Demand Side Substitution Microsoft's actual pricing behavior is consistent with the proposition that the rm enjoys monopoly power in the market for Intel-compatible PC operating systems. The company's decision not to consider the prices of other vendors' Intel-compatible PC operating systems when setting the price of Windows 98, for example, is probative of monopoly power. U.S. District Judge Thomas Peneld Jackson

21 Outline Cost Function Prot Maximization Perfect Competition Market Power Monopoly Eciency Market Power: A Second Look

22 Monopoly Optimization Problem Industry has one rm, who faces downward-sloping industry demand curve. Two equivalent formulations: First, monopolist chooses quantity to maximize prots: max Q P(Q) Q C(Q). Alternatively, monopolist chooses price to maximize prots: max P Q(P) C(Q(P)) P where Q(P) is demand curve. FOC: MR = MC.

23 Marginal Revenue of a Monopolist

24 Monopoly - Optimal Strategy Let's come back to the monopolist optimizing problem. Monopolist chooses price to maximize prots: max Q π=p(q) Q C(Q) where Q(P) is demand curve. Example: Linear demand, constant marginal price max Q π=(a bq) Q c Q. We will get Q Monopoly = a c 2b, PMonopoly = a+c 2 and π = (a c)2 2b.

25 Elasticity Elasticity is the measurement of how responsive an economic variable is to a change in another. Price elasticity of demand measures the percentage change in quantity demanded in response to a one percent change in price. ɛ = % Q % P = dq/q dp/p.

26 Inelastic Demand Petrol petrol has few alternatives because people with a car need to buy petrol. For many driving is a necessity. There are weak substitutes, such as train, walking and the bus. Salt. If the price of salt increased, demand would largely be unchanged. It is only a small % of income and people tend to buy infrequently. It is a good with no real substitutes at all. Tap water-this is why tap water is regulated by the government. Diamonds. A cut in price wouldn't increase demand very much. Peak rail tickets. Cigarettes - smokers are addicted. Apple iphones, ipads.

27 Monopoly - A Second Look Monopolist chooses price to maximize prots: max P π=p Q(P) C(Q(P)) The FOC condition implies P MC(Q(P)) P = 1 dq P dp Q = 1 ɛ. These properties doesn't reply on functional form of demand. Across monopolistic markets, should observe negative relationship between price and demand elasticity.

28 Market Power and Elasticity The Lerner Index is dened as the ratio of the rm's prot margin P MC and its price. L = P MC P It is a measure of market power since it is increasing in the price distortion between price and marginal cost. We have shown L = P MC P. = 1 ɛ. In general a rm may have market power and not be a monopolist. The extent to which a rm in imperfectly competitive markets can exercise market power depends on the elasticity of its demand curve.

29 Outline Cost Function Prot Maximization Perfect Competition Market Power Monopoly Eciency Market Power: A Second Look

30 Measures of Gains from Trade Consumer Surplus How much would a consumer have to be paid to forgo the opportunity to purchase as much as she wants of a good at a given price? Consumer surplus is the dierence between the consumer's willingness to pay for another unit of output and the price actually paid. Producer Surplus How much would a producer have to be compensated in order to forgo the opportunity to sell as much as she wants at a given price? Producer Surplus is dierence between the producer's revenues and total avoidable costs.

31 Gains from Trade in Competitive Equilibrium

32 Welfare in a Monopolistic Market

33 Calculation Monopoly pricing with constant marginal costs and linear demand (i) Demand is linear P(Q) = a bq, (ii) Marginal cost is constant and equal to c. Monopoly quantity:q m = a c 2b. Monopoly price:p m = a c 2b. Monopoly prots: π m = (a c)2. 4b Social optimal quantity: Q opt = a c. This is twice as b large as the monopoly output Dead Weight Loss: DWL = (a c)2 8b. Consumer surplus: CS = (a c)2 8b.

34 Ineciency of Monopoly Pricing Monopoly pricing aects both the magnitude of gains from trade and their distribution. Monopoly pricing is inecient since the monopolist produces too few units. The dierence between the total surplus under monopoly and maximum total surplus is called deadweight loss A second eect of monopoly power is the transfer of surplus from consumers to the rm as prots. Under competitive pricing, both monopoly prots and the deadweight loss would have gone to consumers as surplus.

35 Benets of Monopoly Scale economies: if a merger to monopoly results in a decrease in industrywide costs, these cost savings could compensate for increase in allocative ineciency. Research and development: Schumpeter (1965) argued that market power is a necessary incentive for research and development.

36 Outline Cost Function Prot Maximization Perfect Competition Market Power Monopoly Eciency Market Power: A Second Look

37 Market Power in a Longer Time-Frame The extent of the ineciency associated with market power also depends on the time frame. In the long run, a rm's elasticity of demand is likely to be larger. Consumer response: For instance, homeowners who use electricity to heat their homes are unlikely to switch to natural gas when the price of electricity rises. New entrants: OPEC's exercise of market power in the 1970s created protable entry opportunities in non-opec countries. New technology: In the 1980s Nintendo dominated the market for 8-bit video systems. The industry changed from a monopoly to a duopoly with the introduction by Sega of 16-bit players.

38 Durability Dierent goods have dierent degrees of durabilityconsider the pattern of consumption services over time from (i) a banana; (ii) a compact disc; and (iv) a diamond

39 The Coase Conjecture Ronald Coase (1972) conjectured that durability and expectations might substantially reduce or eliminate the market power of a monopolist supplier of a durable good.

40 The Coase Conjecture - Example Consider a durable goods monopolist with two units of a durable good. There are only two consumers and they dier by their reservation prices (WTP): 15 and 10. If the monopolist wants to sell the goods in two period, what price does it set at period two? Why does the high type consumer buy at the rst period? What is the maximum price that the monopolist can set at the rst period? What the prots would be if the seller sell goods in one period?

41 So... What Can Monopolists Do? The practical importance of Coase's insight is not that in certain circumstances the monopoly power of a durable goods monopolist disappears. Rather, it is that the ability of consumers to arbitrage across time will constrain the market power of a monopolist. It is the expectation on the part of consumers that prices will fall that puts downward pressure on current prices. From the perspective of the monopolist, she can increase her prots if she can convince consumers that prices will not fall in the future. De Beers, Disney.

42 Summary Prot-maximizing rms produce where their marginal revenue equals marginal cost. A rm with market power can protably raise price above marginal cost. The market power of a rm varies inversely with its elasticity of demand. The exercise of market power creates an opportunity cost to society called deadweight loss. DWL provides an economic rationale for state intervention.