Market Power

The ability of price setting firms

to raise price without losing all sales
Measurement of Market Power
•Elasticity of Demand
• A firm’s ability to raise price without significantly affecting the quantity
demanded of its product is inversely related to the price elasticity of
demand for the product
• Market power is greater the less elastic its demand
•Lerner Index
• Measures the extent to which price deviates from the price that would
exist under competition
If the firm is a price taker, P = MC, the Lerner
Index is equal to zero

The greater the value of the index, the greater

the degree of market power
Monopolistic Competition
1. firms sell differentiated products
• prevents the demand curve from being horizontal
due to real or perceived differences
2. highly substitutable but not perfect
substitutes (large cross-price elasticity but not
infinite)
3. free entry and exit
$
Per
Unit

Short Run
MC
P
AC

MR = MC

DSR

Q MRSR q
$
Per
Unit

Long Run

MC

AC

P MR = MC

D
MR

q
q
Economic Efficiency
1. MR = MC but P does not equal MC --- P > MC -- additional
units of output worth more to consumers than costs firm to
produce
2. relative to monopoly these firms likely will have lower profits,
greater output, and lower prices
3. excess capacity -- output < min AC
THUS, consumers are worse off relative to perfect competition.
Oligopoly
Characteristics
•relatively small number of firms offering a product or
service
•product may be differentiated or undifferentiated
•main characteristic of industry is that the number of
firms is so small that an action taken by one firm has an
effect on the sales of another
Cournot Model
•Intense rivalry
•in determining its profit maximizing output level, the
assumption is that the other firm’s output will not change
P = 1,000 - QS - QT
TCS = 70,000 + 5QS + 0.25QS2
TCT = 110,000 + 5QT + 0.15QT2
Siemen’s total profit is equal to:
PS = PQS - TCS
= (1,000 - QS - QT)QS - (70,000 + 5QS + 0.25QS2)
= -70,000 + 995 QS - QTQS - 1.25QS2
dPS/dQS = 995 - QT - 2.50QS

Thomson’s profit is equal to

PT = PQT - TCT
= (1,000 - QS - QT)QT - (110,000 + 5QT + 0.15QT2)
= -110,000 + 995QT - QSQT - 1.15QT2

dPT/dQT = 995 - QS -2.30QT

To maximize profit, set equations equal to zero

dPS/dQS = 995 - QT - 2.50QS = 0

dPT/dQT = 995 - QS -2.30QT = 0

QT + 2.50QS = 995
QS +2.30QT = 995

QS = 272.32
QT = 314.20
P = $413.48
Cartels and Collusion
•Cartel – formal agreements among
oligopolists
How do Cartels Operate?
•Profits often are divided among firms on the basis of their
individual level of production
•Other allocation techniques may be employed
• Market share (before collusion)
• Production capacity (before collusion)
• Bargained solution
Price Fixing (Collusion) is easier when…
• Industry regulators are weak/ ineffective
• Penalties for collusion are low relative to the potential gains in
revenues/ operating profits
• Participating firms have a high percentage of total sales – this
allows them to control market supply
• Firms can communicate well and trust each other and they have
similar strategic objectives
• Industry products are standardized and output is easily
measurable
• Brands are strong so that consumers will not switch demand when
collusion raises price
Cartels tend to be Short-lived
•In LR, changing products and entry by new producers can pose
a threat
•In SR, disagreements among members
• Might agree maximizing joint profits is mutually beneficial
• Often disagree on the fairness of the profit-sharing schemes
• Subversion by a cartel member can be quite lucrative
• RISK: Over-supply threatens stability of cartel
Cartels tend to be Short-lived
profit maximization and division of output two firm cartel

PTOTAL = PS + PT

PTOTAL = (1,000 - QS - QT)QS - (70,000 + 5QS +

0.25QS2) + (1,000 - QS - QT)QT - (110,000 + 5QT
+ 0.15QT2)

= -70,000 + 995 QS - QTQS - 1.25QS2 -110,000 +

995QT - QSQT - 1.15QT2

= -180,000 + 995 QS - 1.25QS2 + 995QT - 1.15QT2

- 2 QSQT
• take partials of the above with respect to
QS and QD

• dPTOTAL/dQS = 995 - 2.50QS - 2QT

• dPTOTAL/dQT = 995 - 2.30QT - 2Qs

• setting these expressions equal to zero

• 2.50QS + 2QT -995 = 0

• 2.30QT +2QS -995 = 0

• QS = 170.57 (172.88)

• QT = 284.29 (281.40)

• P = $545.72
comparison between cournot and cartel

•total industry output is lower and selling price is higher

when the two firms collude
•total industry profits are higher when the firms work
together to set prices and output levels
Price Leadership
•Barometric
•Dominant Firm
Price Leadership
•Barometric – one (or a few firms) set the price
ØAnnounce price and hope others follow
ØExamples:
üAirline industry
üBanks
Dominant Firm
•One firm establishes self as leader
•Usually 40% or more market share
•No collusion or cooperation
•acts as a monopolist in its segment of the market
•sets its MC = MR for its segment
Example
• P = 10,000 - 10QT

• where QT = QL + QF

• MCL = 100 +3QL

• SMCF = 50 +2QF

• MRL = MCL
• TR = P*Q
L L

•Q = Q - Q
L T F

• Q = 1,000 - 0.10P
T

• MR = P
F

• MR = SMC
F F
• remember SMC = 50 +2Q
F F

• so P = 50 +2Q F

• Q = 0.50P - 25
F

• remember Q = Q - Q and Q
L T F T = 1,000 - 0.10P

• Q = 1,000 - 0.1P - 0.50P + 25

L

• Q = 1,025 - 0.6P
L
• P = 1,708.3333 - 1.6667Q L

• and TR = P*Q
L L

• so TR = 1,708.3333Q - 1.6667Q
L L L
2

• MR = 1,708.3333 - 3.3334Q
L L

• remember dominant firm’s maximizing output is

where MRL = MCL

• 1,708.3333 - 3.3334QL = 100 + 3QL

• 6.3334Q = 1,608.3333
L

• Q = 253.945
L

• P = 1,708.3333 - 1.6667QL

• P = 1,708.3333 - 1.6667(253.945)
• P = $1,285.083
• remember Q = 0.50P - 25
F

• Q = 0.50 (1,285.083) - 25
F

• Q = 642.54 -25
F

• Q = 617.542
F
Monopoly
Monopoly
•Sole producer of product that has no substitutes
•demand curve facing monopoly is total demand curve
for product
Characteristics of Monopoly
1. control of inputs
2. economics of scale -- natural monopoly
3. patents
4. licenses
5. entry lags
Price and Output Determination
P = a – bQ

TR = P * Q

TR = aQ – b Q2

MR = dTR/dQ = a – 2bQ the slope of the MR function is twice that of

the demand function

Profit maximization occurs where MR = MC

Numerical Example
• P = 100 - Q, where MC = 20.
• Find where MR = MC
• TR = P•Q = 100•Q - Q2
• MR = 100 - 2•Q = 20
• 80 = 2•Q
• QM = 40
• Find the monopoly price:
• PM = 100 - 40 = 60
P Profit Maximizing Output of Monopoly

MC

Pe

MR D

Qe Q
Not enough information to determine profit

•Must add AC curve

•profit or loss in SR or LR
P Excess or Monopoly Profit

MC
AC
Pe

AC

MR D

Qe Q
 Loss

P AC
Won’t operate in LR with a loss

MC
AC

Pe

MR D

Qe Q
Limit pricing
• monopoly charges a lower price than it could by setting MR=MC in
order to discourage entry by potential competitors.
• Forgoes some of the SR profits in order to maintain monopoly
position longer.
• Price set somewhere between where MC=MR and P=AC
 P Limit Pricing

ACc

P1 MC
AC

PL

ACmin
P = AC

D
MR

Q1 QL Q
 Comparing Monopoly and Perfect Competition

$
Consumer surplus in monopoly

Consumer surplus in PC
Pm

Deadweight Loss

P LS = AC = MC
Firm Revenue in
Monopoly
Firm Revenue in PC

Qm Q
MR Qo
Comparing Monopoly and Perfect
Competition
•Higher price in monopoly than PC
•Lower quantity produced in monopoly than PC
•Smaller consumer surplus in monopoly than
PC
•Loss of efficiency in monopoly compared to
PC. Shown by the existence of deadweight
loss triangle