This is a Power Point presentation on markets

This is a Power. Point presentation on markets where firms have some degree of market power. A left mouse click or the enter key will add and element to a slide or move you to the next slide. The back space key will take you back an element or slide. If you wish to exit the presentation, the escape key will do it! 1 R. Larry Reynolds ã 1997

Market Power · In pure competition sellers are “price takers. ” · No seller [or buyer] has the ability to influence the market price. · In most markets, at least one or more of the conditions required for pure competition are violated. This gives sellers or buyers the ability to influence the market price and allocation of resources 2

Market Power · Market power is the ability of an agent to influence the price of a good they sell or buy and to alter the allocation of resources. · Sources of market power: · monopoly, oligopoly, monopolistic competition · monopsony, oligopsony · Institutional structure {laws, regulations customs, mores, . . . } 3

Market Power Among Sellers · Monopoly - a single seller of a good with no close substitutes and barriers of entry. · Oligopoly - a market characterized by significant barriers to entry and “a few “ sellers who recognize their interdependence in the market; products may be homogeneous or differentiated. · Monopolistic competition - a market with a large number of sellers and relatively free entry; each firm “differentiates” its product. 4

Other Forms of Market Power · Monopsony - a single buyer of a resource or good. · Oligopsony - a market characterized by “a few” buyers” of a resource or good. · Bilateral monopoly - a market where a monopolist sells to a monopsonist. · Cartel - an organization of sellers who engage in collusion to control output and price. 5

Barriers To Entry [BTE] · Social or political institutions or economic conditions that prevent firms from entry into a market. · laws, regulations, patents, copyrights, trademarks, . . . · location, natural ability, information, economics of scale (natural monopolies) 6

Monopoly · A monopoly · single seller · the good produced and sold has no close substitutes · Barriers to entry prevent others from competing · in the short, run the firm can alter the price and output; the firm is a “price maker” {or “price setter”} 7

REVENUE FUNCTIONS FOR MONOPOLIST Since there is only one seller, the market demand is the demand faced by the firm. market demand & demand $ The monopolist can set faced by monopolist their price which determines AR = D the amount they can sell. At the mid-point of demand, the price elasticity of demand, ep = - 1. At this quantity the maximum TR ocurrs. At the max. of TR its slope is 0. Therefore, MR = 0. . ep = - 1, TR = max, D = AR MR The MR “bisects” the area under AR, its slope is 2 X the slope of AR. MR=0 X/2 X Q/ut 8

A linear, negatively sloped demand function; P = a - m. Q TR = PQ =(a - m. Q) Q TR = a. Q - m Q 2 TR TR = a. Q - m Q 2 is a nonlinear function. MR = ¶TR ¶Q = a - 2 m. Q MR = a - 2 m. Q The slope of MR is twice the slope of AR or demand. At the maximum of TR, its slope is 0; MR = 0 P a TR D = AR MR Q 9

SHORT RUN PROFIT MAXIMIZATION The market demand determines the revenue functions of the monopolist. The MC and ATC are determined by the production function and prices of the inputs. To maximize p, the firm will produce where MC=MR. The monopolist will produce QMwhich can , be sold at a price PM. The AC at output QM is CM. $ Monopoly Firm PM > MC AC PM CM CMin MC . QM MR QC The output with the minimum cost per unit is at QC , the equilibrium output level in pure competition. D = AR Q/ut 10

MONOPOLY PROFITS Given the revenue and cost functions faced by the monopolist, the firm maximizes p where MC = MR. Output is QM at price PM. Total revenue is calculated: TR = PM QM AC is CM Total cost is; PM TCM = QM CM Remember that “normal p” is included in costs. Monopoly Firm $ CM “Economic p” = TR - TC MC PM > MC . AC TR = PM QM p TCM= QM CM In a monopoly there are BTE so, there is no entry to capture the above normal p; the firm continues to earn above normal or “monoply p. ” QM MR D = AR Q/ut 11

WELFARE LOSSES IN MONOPOLY Monopoly profits are: (PM - CM ) QM = p. Monopoly Firm $ The MC of all units up to Q* is less than what buyers are willing and able to pay. Buyers “value” all units up to Q* more than the MC PM of producing those units. MB > MC. CM m AC p The welfare loss to society is the area above the MC and below the demand function. [Area fhm. ] The monopolist restricted output and raised price above MC. MC h f D = AR MR QM Q* Q/ut 12

Market Power · When a firm faces a negatively sloped demand function for their product, they can raise the price above MC and reduce output · Buyers are willing to purchase a good so long as marginal benefits are equal to or greater than the price, they buy until MB =P · MB = P > MC; The benefits of the last unit sold exceed the costs of producing that unit. 13

Demand Marginal Revenue · · · The demand AR are the same thing. MR is the change in TR associated with a change in quantity sold. Remember that when a marginal value is less than the average, the average is decreasing. On a graph, when the AR is decreasing, MR must be below the AR. When a demand function is negatively sloped it is the same as AR decreasing. Therefore, in the absence of price discrimination, MR will lie below the Demand function. 14

Monopolistic Competition · Large number of sellers · relative ease of exit / entry · products are differentiated · actual differentiation · perceived differentiation · Only difference from pure comp is that the demand faced by the firm is not perfectly elastic; MR will lie below the Demand function [AR] 15

Monopolistically competitive firms have differentiated products but must compete with other sellers of goods that are close subsitutes. The result is that each firm faces a negatively sloped demand function that is “relatively elastic. ” If there are “below normal p “ some firms will exit and the demand for remaining firms will shift out. Above normal p will encourage entry and each firm’s demand function will shift in and may become more relatively more “elastic. ” $ D D’ D* Q /ut As firms enter there are more close substitutes so each firms’ demand shifts in and is relatively more elastic. 16

$ ATC! ATC 2 ATC 3 ATC* ATC 5 ATC 6 LRAC D D* Q/ut Given the production function and the prices of inputs, the average cost functions for the monopolistically competitive firm are determined. A firm who faces a demand function D will be able to earn above normal p. Firms will enter, shifting the demand to the left and reducting its slope. Once D* is tangent to LRAC [LRAC= AR= D] there is no reason for others to enter or exit. Long run equilibrium. 17

$ ATC! MC ATC 2 ATC 3 ATC* ATC 5 LRAC P= C* MR Q* ATC 6 D* Q/ut At this point the firm will elect to build plant ATC 3 and produce Q* output. At Q* output the firm has an average cost of C* which is also the Price and average revenue. The firm earns a normal profit. The firm builds a plant that is “too small” and operates it at less than an efficient level of output. The “excess capacity theorem. ” 18

Oligopoly · Characteristics: · A “few sellers” who recognize their interdependence · Products may be homogeneous or differentiated · Significant barriers to entry exist · Explanations of oligopoly behavior require knowledge of competititors’ behavior 19

Kinked Demand Model · An oligopolist whose price and output choice is dependent on competitors’ behavior. · Firms tend to have capacity to increase output · Consumers see goods as subsitutes · Two service stations at an off-ramp 20

Station A $ gas /ut 21

P= Cmin Q* 22

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1 2 3 4 5 6 24 ut

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Utility X Q 1 2 3 4 5 6 7 8 TU 30 55 75 90 105 100 26