(absolute market power)
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MONOPOLYMONOPOLY
(absolute Market power)
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FEATURESFEATURES
Single firmSingle firm
Produces & sells a particular good or Produces & sells a particular good or
service for which there are no perfectservice for which there are no perfectsubstitutessubstitutes
New firms are prevented from enteringNew firms are prevented from enteringmarketmarket
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MARKET POWERMARKET POWER
Ability of a firm to raise price without losing all itsAbility of a firm to raise price without losing all its
salessales
Gives firm ability to raise price above average costGives firm ability to raise price above average cost& earn economic profit (if demand & cost conditions& earn economic profit (if demand & cost conditions
permit)permit)
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MEASUREMENT OF MARKET POWER (1)MEASUREMENT OF MARKET POWER (1)
Degree of market power inversely related to price
Degree of market power inversely related to price
elasticity of demand
elasticity of demand
The less elastic the firm’s demand, the greater The less elastic the firm’s demand, the greater
its degree of market power its degree of market power The fewer close substitutes for a firm’s product,The fewer close substitutes for a firm’s product,
the smaller the elasticity of demand (inthe smaller the elasticity of demand (in
absolute value) & the greater the firm’s marketabsolute value) & the greater the firm’s market
power power
When demand is perfectly elastic (demand isWhen demand is perfectly elastic (demand is
horizontal), the firm has no market power horizontal), the firm has no market power
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MEASUREMENT OF MARKET POWER (2)MEASUREMENT OF MARKET POWER (2)
Lerner index measures proportionate amount by whichLerner index measures proportionate amount by which
price exceeds marginal cost (note that P = MC in Perfectprice exceeds marginal cost (note that P = MC in Perfect
comptt):comptt):
P MC
P
−=Lerner index
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MEASUREMENT OF MARKET POWERMEASUREMENT OF MARKET POWER
Lerner indexLerner index
Equals zero under perfect competitionEquals zero under perfect competition
Increases as market power increasesIncreases as market power increases
Also equalsAlso equals –1/E –1/E , which shows that the index, which shows that the index
(& market power), vary inversely with elasticity(& market power), vary inversely with elasticity
The lower the elasticity of demand (absoluteThe lower the elasticity of demand (absolute
value), the greater the index & the degree of value), the greater the index & the degree of market power market power
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MEASUREMENT OF MARKET POWER (3)MEASUREMENT OF MARKET POWER (3)
If consumers view two goods as substitutes, cross-If consumers view two goods as substitutes, cross-
price elasticity of demandprice elasticity of demand (E (E XY XY ) ) is positiveis positive
The higher the positive cross-price elasticity,The higher the positive cross-price elasticity,
the greater the substitutability between twothe greater the substitutability between twogoods, & the smaller the degree of marketgoods, & the smaller the degree of market
power for the two firmspower for the two firms
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DETERMINANTS OF MARKET POWERDETERMINANTS OF MARKET POWER
Entry of new firms into a market erodes market power Entry of new firms into a market erodes market power of existing firms by increasing the number of of existing firms by increasing the number of substitutessubstitutes
A firm can possess a high degree of market power A firm can possess a high degree of market power
only whenonly when strong barriers to entry strong barriers to entry existexist Conditions that make it difficult for newConditions that make it difficult for new
firms to enter a market in which economicfirms to enter a market in which economicprofits are being earnedprofits are being earned
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COMMON ENTRY BARRIERSCOMMON ENTRY BARRIERS
(I) Economies of scale(I) Economies of scale
When LAC declines over a wide range of When LAC declines over a wide range of
output relative to demand for the product,output relative to demand for the product,
there may not be room for another largethere may not be room for another largeproducer to enter marketproducer to enter market
(II) Barriers created by government(II) Barriers created by government
Licenses, exclusive franchises, patent rightsLicenses, exclusive franchises, patent rights
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COMMON ENTRY BARRIERSCOMMON ENTRY BARRIERS
(III) Input barriers(III) Input barriers
One firm controls a crucial input in theOne firm controls a crucial input in the
production processproduction process
(IV) Brand loyalties(IV) Brand loyalties
Strong customer allegiance to existing firmsStrong customer allegiance to existing firms
may keep new firms from finding enoughmay keep new firms from finding enoughbuyers to make entry worthwhilebuyers to make entry worthwhile
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DEMAND & MARGINAL REVENUE FOR ADEMAND & MARGINAL REVENUE FOR A
MONOPOLISTMONOPOLIST
Market demand curve is the firm’s demand curveMarket demand curve is the firm’s demand curve
Monopolist must lower price to sell additional unitsMonopolist must lower price to sell additional unitsof outputof output
WhenWhen MRMR is positive (negative), demand is elasticis positive (negative), demand is elastic(inelastic)(inelastic)
For linear demand,For linear demand, MRMR is also linear, has the sameis also linear, has the samevertical intercept as demand, & is twice as steepvertical intercept as demand, & is twice as steep
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DEMAND & MARGINAL REVENUE FOR ADEMAND & MARGINAL REVENUE FOR A
MONOPOLISTMONOPOLIST
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SHORT-RUN PROFIT MAXIMIZATION FORSHORT-RUN PROFIT MAXIMIZATION FOR
MONOPOLYMONOPOLY
Monopolist attains maximum profits by producing thatMonopolist attains maximum profits by producing that
level of O/P for which positive difference b/w TR & TC islevel of O/P for which positive difference b/w TR & TC is
greatestgreatest
Profit maximization occurs by producing quantity for Profit maximization occurs by producing quantity for
whichwhich MR = MC MR = MC
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SHORT-RUN PROFIT MAXIMIZATION FORSHORT-RUN PROFIT MAXIMIZATION FOR
MONOPOLYMONOPOLY
If If P P >> ATC ATC , firm makes economic profit, firm makes economic profit
If If ATC ATC >> P P >> AVC AVC , firm incurs loss, but continues to, firm incurs loss, but continues to
produce in short runproduce in short run
If demand falls below AVC at every level of output, firmIf demand falls below AVC at every level of output, firmshuts down & loses only fixed costsshuts down & loses only fixed costs
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SHORT-RUN PROFIT MAXIMIZATION FORSHORT-RUN PROFIT MAXIMIZATION FOR
MONOPOLYMONOPOLY
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SHORT-RUN LOSS MINIMIZATION FORSHORT-RUN LOSS MINIMIZATION FOR
MONOPOLYMONOPOLY
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LONG-RUN PROFIT MAXIMIZATION FORLONG-RUN PROFIT MAXIMIZATION FOR
MONOPOLYMONOPOLY
Monopolist maximizes profit by choosing to produceMonopolist maximizes profit by choosing to produceoutput whereoutput where MR = LMC MR = LMC , as long as, as long as P P ≥≥ LAC LAC
Will exit industry if Will exit industry if P P << LAC LAC
Monopolist will adjust plant size to the optimal levelMonopolist will adjust plant size to the optimal level
Optimal plant is where the short-run averageOptimal plant is where the short-run averagecost curve is tangent to the long-run averagecost curve is tangent to the long-run averagecost at the profit-maximizing output levelcost at the profit-maximizing output level
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LONG-RUN PROFIT MAXIMIZATION FORLONG-RUN PROFIT MAXIMIZATION FOR
MONOPOLYMONOPOLY
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EXERCISEEXERCISE
Suppose that the TC equation for a monopolist is givenSuppose that the TC equation for a monopolist is givenby:by:
TC = 500 + 20 QTC = 500 + 20 Q22
The demand equation be:The demand equation be:
P = 400 – 20 QP = 400 – 20 QWhat are the profit maximizing price & quantityWhat are the profit maximizing price & quantity
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SolutionSolution
MR = MCMR = MC
Q = 5Q = 5
P = 300P = 300
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SOCIAL COST OF MONOPOLY: ALLOCATIVESOCIAL COST OF MONOPOLY: ALLOCATIVE
INEFFICIENCY & INCOME REDISTRIBUTIONINEFFICIENCY & INCOME REDISTRIBUTION
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EXCERCISEEXCERCISE
Petersen & Lewis Pg # 337Petersen & Lewis Pg # 337
Problem 9.8Problem 9.8
Problem 9.9Problem 9.9