Lecture Notes 7

Market Power and Monopoly

Prof. Geunyong Park

 Outline
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➢ Preliminary Discussion
➢ Market Power

➢ Economics of Monopoly with Simple Pricing Strategies

➢ Monopolistic Equilibrium
➢ Rule of Thumb Pricing
➢ A Multi-plant Monopoly
➢ Social Costs of Monopoly
➢ Examples of Monopoly
➢ Natural Monopoly
 Market Power
3

➢ Market Power
Ability of a seller or buyer to affect the price of a good (or other
market outcome)

➢ Sources of Market Power

➢ Product differentiation
➢ Access to unique resources
➢ Control over intellectual property, patent and copy rights
➢ Economies of scale (electricity distribution)
➢ Regulation (natural gas, public transportation)
 Two Approaches to Measure Market Power
4

➢ Market power can be measured with some different ways.

➢ We prefer the following simple measures. However, no single one is

perfect.

A. Concentration Measures:
1) Concentration Ratio (CRn)
2) Herfindahl-Hirschman Index (HHI)

B. Performance Measure:
1) Lerner Index (LI)

4
 Concentration Measures: CRn and HHI
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Firm Rank Market Share (%) Squared Market Share

1 25 625
2 25 625
3 25 625
4 5 25
5 5 25
6 5 25
7 5 25
8 5 25
Concentration Index CR4 = 80 HHI(H) = 2,000
 Concentration Measures: Lerner Index
6

➢ Market performance is often measured using the Lerner Index:

𝑃 − 𝑀𝐶
𝐿𝐼 =
𝑃

➢ Perfect competition: LI = 0 since P = MC

➢ Monopoly: 0<LI ≤1 since P>MC

➢ Lerner Index can be a useful measure for the market structure, but has its own
misspecification:
➢ A dominant firm may charge a low price to prey upon competitors or to
deter new entrants (predatory or preemptive practices)
➢ A severe price-competition even among “few” firms may lead to near-
competitive prices
 Demand and Marginal Revenue
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➢ Marginal Revenue (MR)

Change in revenue resulting from a one-unit increase in output
➢ Market Demand is the monopolist’s individual demand as well
➢ Marginal revenue curve is located below demand curve.

TOTAL REVENUE MARGINAL REVENUE AVERAGE REVENUE

PRICE (P) QUANTITY (Q) (R) (MR) (AR)
$6 0 $0 — —
5 1 5 $5 $5
4 2 8 3 4
3 3 9 1 3
2 4 8 −1 2
1 5 5 −3 1
 Average and Marginal Revenue Curves
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➢ Average and marginal revenue are

shown for the demand curve:
𝑃 = 6−𝑄

➢ How to determine AR and MR?

𝑇𝑅 𝑃 × 𝑄
𝐴𝑅 = = =𝑃 =6−𝑄
𝑄 𝑄
𝑑𝑇𝑅 𝑑 6 − 𝑄 𝑄
𝑀𝑅 = = = 6 − 2𝑄
𝑑𝑄 𝑑𝑄

➢ In the case of linear demand curves,

the MR curve has the same price
intercept as the demand curve and
twice the slope.
 The Monopolist’s Output Decision
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➢ As we know, the optimal quantity

(𝑄 ∗ ) is determined at 𝑀𝑅 = 𝑀𝐶.

➢ If the firm produces a smaller

output (𝑄1 ), it sacrifices some
profit that could be earned from
producing more because 𝑀𝑅 >
𝑀𝐶.

➢ Expanding output from 𝑄 ∗ to 𝑄2

would reduce profit because the
additional cost would exceed the
additional revenue.
 Finding the " Sweet Spot "Algebraically
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➢ Invert the demand curve: solve for 𝑃 in terms of 𝑄.

➢ Multiply the inverse demand curve to get 𝑇𝑅 = 𝑃 × 𝑄.

𝑑𝑇𝑅
➢ Differentiate total revenue to get 𝑀𝑅 = .
𝑑𝑄

➢ Solve for 𝑸 by setting 𝑀𝑅 = 𝑀𝐶.

➢ Solve for 𝑷 by substituting profit-maximizing 𝑄 back into the inverse

demand curve.
 A Rule of Thumb for Pricing
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➢ With limited knowledge of average and marginal revenue, we can

derive a rule of thump that can be more easily applied in practice.
➢ First, write the expression for marginal revenue:

𝑑𝑇𝑅 𝑑(𝑃 × 𝑄)
𝑀𝑅 = =
𝑑𝑄 𝑄
➢ By applying Product Rule, we have:

dP Q dP
MR = P + Q = P(1+ )
dQ P dQ

𝑃 𝑑𝑄
➢ Note that = 𝑃𝐸𝐷, measured at the profit-maximizing output:
𝑄 𝑑𝑃
dP 1
MR = P + Q = P(1+ )
dQ PED
 A Rule of Thumb for Pricing
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➢ Now, because a firm’s objective is to maximize profit, we can set

marginal revenue equal to marginal cost:
1
P(1+ ) = MC
PED
➢ Equivalently, we can rearrange this equation to express price directly as
a markup over marginal cost:
MC
P=
1
1+
PED
 Example: ASTRA-MERCK prices Prilosec
13

In 1995, a new drug developed by Astra-Merck became

available for the long-term treatment of ulcers. The drug,
Prilosec, represented a new generation of antiulcer
medication.

By 1996, it had become the best-selling drug in

the world and faced no major competitor.
Astra-Merck was pricing Prilosec at about $3.50 per daily dose.
The marginal cost of producing and packaging Prilosec is only about 30 to 40 cents
per daily dose.
The price elasticity of demand, PED, should be in the range of roughly −1.0 to −1.2.

MC 0.35 0.35
P= = = = 3.89
1 1 0.09
1+ 1+
PED (-1.1)
 Example: Supermarkets and Convenience Stores
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The market demand for food is elastic.

Hence, no single supermarket can raise its
prices very much without losing customers to other
stores.
The elasticity of demand for any one supermarket is
often as large as −10. We find
P = MC/(1 − 0.1) = MC/(0.9) = (1.11)MC.
The manager of a typical supermarket should set prices about 11 percent above
marginal cost.
Small convenience stores typically charge higher prices because its customers are
generally less price sensitive.
Because the elasticity of demand for a convenience store is about −5, the markup
equation implies that its prices should be about 25 percent above marginal cost.
(P = MC/(1 − 0.2) = MC/(0.8) = (1.25)MC.)
 A Multi-plant Monopoly
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➢ You have two water-bottling plants, one in Indonesia and another in

Malaysia. You import water from the two plants and sell in Singapore.
Your need to decide:
➢ How many to sell at Singapore at what price

➢ How many to import from each plant

 A Multi-plant Monopoly
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➢ What should its total output be, and how much of that output should
each plant produce? We can find the answer intuitively in two steps.
➢ Step 1. Whatever the total output, it should be divided between the two plants
so that marginal cost is the same in each plant. Otherwise, the firm could reduce
its costs and increase its profit by reallocating production.

𝑀𝐶1 = 𝑀𝐶2 = 𝑀𝐶𝑇

➢ Step 2. We know that total output must be such that marginal revenue equals
marginal cost. Otherwise, the firm could increase its profit by raising or lowering
total output.
𝑀𝑅 = 𝑀𝐶𝑇
 A Multi-plant Monopoly
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➢ A firm with two plants maximizes

profits by choosing output levels
𝑄1 and 𝑄2 so that marginal
revenue MR (which depends on
total output) equals marginal
costs for each plant, 𝑀𝐶1 and
𝑀𝐶2 .
 Example: A Multi-plant Monopoly
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 Example: A Multi-plant Monopoly
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 Example: Cartel’s Profit Maximization
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➢ A cartel is a group of firms that

collusively determine the price
and output in a market.

➢ The organization of
petroleum‐exporting countries
(OPEC) is the best‐known
example of an international
cartel.

➢ A cartel does not necessarily

divide up market shares equally
among members: higher
marginal cost firms produce less.
 The Social Costs of Monopoly
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➢ Does monopoly power make

consumers and producers better or
worse off?

➢ Under monopoly, the price is

higher and consumers buy less. The
total loss of consumer surplus is
therefore A + B.

➢ The producer gains A but loses C.

The total gain in producer surplus
is therefore A - C. So, the
deadweight loss is given by B + C.
 Price Regulation
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➢ Price regulation can eliminate

the deadweight loss that results
from monopoly power.

➢ When the government imposes

a price ceiling of 𝑃1 the firm’s
average and marginal revenue
are constant and equal to 𝑃1 for
output levels up to 𝑄1 .

➢ For larger output levels, the

original average and marginal
revenue curves apply.
 Antitrust and Competition Laws
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➢ Government may intervene to make a market shift toward a more

competitive outcome and reduce deadweight loss by law enforcement.

➢ Antitrust and competition laws promote competition by restricting firms

from certain behavior that might limit competition.
➢ ban on collusion among competitors with regard to pricing.

➢ prevent firms from merging with or acquiring other firms if doing so

will increase market power.
 Competition Policy in Singapore
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➢ Competition and Consumer Commission of Singapore (CCCS) oversees

anti-competitive activities.

➢ Competition Act (effective since 2004) is the law in Singapore that

protects consumers and business from anti-competitive activities.
➢ Abuse of dominance

➢ Anti-competitive agreements

➢ Merger and acquisition (M&A)

 Example: Grab-Uber merger
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➢ March 2018: Uber sold its Southeast Asian business to Grab, in

exchange for a 27.5% stake.
➢ Made Grab the dominant ride-hailing player in SG market

➢ Grab increased its price by 10-15% after the merger

➢ Exclusivity obligations on taxi companies, car rental partners and

some drivers

➢ CCCS fines $13 million for anti-competitive behavior

➢ “Mergers that substantially lessen competition are prohibited and
CCCS has taken action against the Grab-Uber merger because it
removed Grab’s closest rival, to the detriment of Singapore drivers
and riders," --CCCS chief executive
 Example: China's Baidu Accused of
Search Bias in Monopoly Complaint
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➢ China's largest search engine, Baidu(with 75.5 percent market share), is

facing a potential antitrust investigation after the company was accused
of blocking and degrading the search query results of a Chinese online
encyclopedia website Hudong.

➢ Hudong started its business in 2005, a year before Baidu launched its
own online encyclopedia. Hudong said that its articles on popular topics
are ranked low in the query results when searched on Baidu. Other
search engines such as Google and Microsoft's Bing, however, rank
Hudong's articles at the top.

➢ "We believe that Baidu has used its dominant position to bully and block
competitors."
Pan Haidong, CEO of Hudong.
 Natural Monopoly
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➢ Natural monopoly
A firm that can produce the entire output of the market at a cost that is
lower than what it would be if there were several firms.

➢ Economies of scale may lead to a situation where a single firm services

the entire market for a good.
➢ Economies of scale: long-run average costs decline as output increases.

➢ The beneficial effects of economies of scale may outweigh the

negative effects of market power.
➢ Example: electricity distribution requires an extensive network of
cables (large fixed cost).
 Natural Monopoly
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➢ Because average cost is declining

everywhere, marginal cost is
always below average cost.

➢ If the government push down the

price to the competitive level (𝑃𝑐 ),
the price cannot cover average
cost and the firm would go out of
business.

➢ If the monopolist is broken up into

two competing firms, the average
cost for each would be higher
than the monopolist’s cost.