Market Power: Does It Help Or Hurt the Economy?
Instructor's Manual 2
Chapter 5
Market Power: Does It Help or Hurt the Economy?
What's in This Chapter and Why
This chapter continues the development of the function of competitive markets by showing that a competitive market results in economic efficiency. Thus, the analysis of the price system and the analysis of demand and supply in previous chapters, along with the efficiency analysis contained in Chapter 3 and this chapter provide an introduction to the workings of a competitive market economy.
Chapter 6 and Chapters 7 through 9 are used to consider market failure. The monopoly and market power analysis of this chapter shows one way that markets can result in inefficiency.
The issue raised in the chapter is market power in the U.S. economy. How important is it? It is shown that if market power exists in the U.S. economy, it exists mostly in oligopolies. How do oligopolies achieve monopoly-like results? They may do so, if they can act as if they are in a cartel. The OPEC cartel is discussed because of its intrinsic interest and because it shows conditions necessary for a cartel to be successful.
If government is antagonistic to cartels or collusion--as it is in the United States—it is concluded that competitive pressures will be intense in a large economy.
Instructional Objectives
After completing this chapter, your students should know:
1. The basic monopoly analysis, including a comparison of monopoly equilibrium with competitive equilibrium.
2. Elementary conclusions about competition and economic efficiency.
3. The sources and extent of monopoly in the U.S. economy.
4. The conditions under which a cartel might succeed and be able to discuss OPEC's history in light of cartel analysis.
5. The relationship between market power and economic growth.
Key Terms
These terms are introduced in this chapter:
Instructor's Manual 2
Market power
Monopoly
Oligopoly
Cartel
Marginal revenue
Marginal principle
Efficient output
Barrier to entry
Natural monopoly
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Suggestions for Teaching
The approach taken to demand and supply analysis in Chapter 2 makes the discussion of efficiency easier for students. Depending upon your objectives for the course, you can either emphasize the formal monopoly analysis or you can use intuition to argue that a monopoly will charge a higher price and restrict output. Students are intrigued by the discussion of oligopoly and cartel behavior. The incentives to cooperate and the incentives to cheat can be developed in ways that students relate to. For instance, do students have incentives to "hold back" in classes in which grades are determined on a curve? If so, do students in fact "hold back"?
Students and automobiles are often strong complements. Both the text and boxed discussions of the automobile industry should interest and motivate students.
It is interesting to discuss with students the rationale for and the effect of the licensing of taxis, barbers, and the like. Then, the question of the licensing of physicians or child care centers might be raised.
Additional References
In addition to the references in the text, instructors may wish to read or assign one or more of the following:
1. "A Survey of the Car Industry," The Economist (October 17, 1992).
2. Walter Adams, "Public Policy in a Free Enterprise Economy," Chapter 13 in Walter Adams, ed., The Structure of American Industry, 8th ed. (New York: Macmillan, 1990), pp. 349376.
3. John Kenneth Galbraith, American Capitalism: The Concept of Countervailing Power (Boston: Houghton Mifflin, 1952).
4. Steven Martin, "The Petroleum Industry," Chapter 2 in Walter Adams, ed., The Structure of American Industry, 9th ed. (New York: Macmillan, 1994).
5. F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance, 3rd ed. (Boston: Houghton Mifflin, 1990).
6. "The Fall of Big Business" and "Japanese Cars at Day," The Economist (April 17, 1993), pp. 13-14 and 61-62.
7. Mine K. Yucel and Carol Dahl, "Reducing U.S. OilImport Dependence: A Tariff, Subsidy, or Gasoline Tax?" Federal Reserve Bank of Dallas Economic Review (May 1990), pp. 1725.
Outline
I. GENERAL COMMENTS AND DEFINITIONS
A. Market Power
1. Firms have market power when the following conditions exist.
a. Firms can influence price in attempts to increase profits.
b. The existence of profits does not attract new firms into the industry.
2. The following conditions are required for market power.
a. A few firms control the product.
b. There are limitations on the entry of new firms.
B. Monopoly
1. A monopoly is a single seller of a product with no close substitutes.
C. Oligopoly
1. An oligopoly is a market with a few producers or sellers of a good.
D. Cartel
1. A cartel is an organized group of firms who manage output and pricing as if they were a monopoly.
II. MONOPOLY ANALYSIS
A. Demand
1. Because the monopolist is a single seller, it faces the market demand curve for the product produced.
a. This demand curve is negatively sloped and shows that the monopolist can sell more output only by lowering the price of the product.
1. This means that the output the monopolist chooses to sell affects price.
B. Marginal Revenue
1. Marginal revenue is the change in total revenue associated with selling one more unit of output.
a. It is the private benefit to the monopolist of selling one more unit.
2. For a monopolist, marginal revenue is less than price.
a. Because the monopolist must lower the price on all units in order to sell additional units, marginal revenue is less than price.
b. Because marginal revenue is less than price, the marginal revenue curve will lie below the demand curve.
1. Because demand represents marginal social benefit and marginal revenue represents marginal private benefit, marginal social benefit is greater than industry marginal private benefit in monopoly.
C. The Marginal Principle
1. In choosing the output to produce, the monopolist follows the marginal principle.
a. This principle states the profit maximizing output is that output where marginal revenue equals marginal cost.
1. If marginal revenue is greater than marginal cost, the monopolist should
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increase output.
2. If marginal revenue is less than marginal cost, the monopolist should decrease output.
D. Monopoly and Competition Compared
1. Unlike a competitive industry, a monopoly does not produce the efficient output. Monopolists charge a higher price and produce less output than a competitive industry.
a. Efficient output occurs where marginal social cost and marginal social benefit are equal.
b. Inefficiency occurs because of the divergence between marginal social benefit and marginal social cost.
1. At the output produced by the monopolist, marginal social benefit exceeds marginal social cost.
a. The value to consumers of an additional unit exceeds the value of the units of other goods given up to produce the additional unit - the opportunity cost.
III. MARKET POWER AND ECONOMIC EFFICIENCY
A. The Trend in Market Power
1. Some studies indicate that the U.S. economy is becoming more competitive.
a. Increased competition from imports in the manufacturing sector has decreased market power.
b. Government deregulation of the economy has decreased market power.
c. Federal government policies making mergers and price fixing more difficult have decreased market power.
d. The information revolution has increased competition in many industries, resulting in a decrease in market power.
B. Barriers to Entry
1. There are four major sources of market power in the United States.
a. Technical conditions can create entry barriers.
1. Technical conditions might be such that a technically efficient firm will supply all of a good that consumers wish to purchase at the going price.
a. Monopolies created by these technical conditions are sometimes referred to as natural monopolies.
b. Access to the supply of a product or an essential input for a product can create a barrier to entry.
c. Existing firms may develop and maintain market power through product differentiation.
d. Monopolies may be created by government regulations.
IV. OPEC: A FEW SELLERS ACTING LIKE A MONOPOLY
A. Cartel Formation
1. Three variables are important in determining the success of forming and maintaining a cartel.
a. The cartel must reach an agreement that all producers will abide by.
1. This agreement stipulates the total output to be produced by the cartel and the division of production among the members.
b. The cartel must continue to cooperate and come to new agreements as conditions change.
c. The agreement must be enforced.
1. Because it is very profitable for cartel members to cheat on the original agreement, there must be some method of enforcement.
B. The Determinants of Cartel Success
1. The fewer the number of firms and the more similar they are, the easier it is to form and operate a cartel.
a. As the number of firms increases, it becomes more difficult to include all the firms in the industry.
b. As the number of firms increases, it becomes more difficult to detect cheating on the agreement.
2. If firms are not similar, it becomes more difficult to determine the division of output and profits.
C. Problems of the OPEC Cartel
1. There are three factors accounting for the serious problems encountered by the OPEC cartel.
a. There are many members, as well as several nonmember petroleum producers.
1. The existence of large profits attracted entry to the industry and drove the price of petroleum down.
b. The members are dissimilar in that they have different and conflicting goals.
1. Countries with small reserves relative to population want higher prices now, while countries with relatively large reserves are more concerned with longrun profits.
c. The demand for petroleum is more elastic in the long run.
1. Over time consumers have made adjustments to the higher OPEC price.
V. MARKET POWER AND ECONOMIC GROWTH
A. Basis of Economic Growth
1. Knowledge and the creation of new knowledge are the basis for much economic growth and for the growth of many firms.
2. Knowledge-based firms have several feature that lead to a monopoly or near-monopoly of their products.
a. The development of the product involves huge start-up costs.
b. There are large up-front costs involved in producing the product that has been developed.
3. Government grants monopolies of new products through copyrights and patents so that firms can cover the start-up and up-front costs of developing a product.
a. Microsoft’s first disk of Windows probably cost $50 million. Subsequent disks cost $3.
VI. GOVERNMENT AND MARKET POWER
A. Antitrust Laws
1. Antitrust laws prohibit price fixing and other types of explicit cartel or monopoly behavior.
2. Antitrust laws prohibit mergers in certain instances.
a. A merger is a combination of two or more firms into one firm.
3. Through the use of antitrust laws, government discourages market power.
4. Antitrust laws should not necessarily be used to restructure all firms with market power.
a. If the industry is a natural monopoly, monopoly profit may provide incentives for innovations that, over time, would reduce or eliminate market power.
b. The existence of monopoly profits provides an incentive for economic rent seeking.
c. The existence of profits encourages new firms to come into the industry causing prices to be lowered.
Answers to Review Questions
1. Why does the efficient output occur where marginal benefit equals marginal cost? Analyze in detail.
Efficient output occurs when the value of one more unit of a good equals its cost, where marginal social benefit equals marginal social cost. Observe the following graph, which represents the market for computers.
Suppose that the firm is considering producing an additional computer which will expand output to Q1. At Q1, the demand price is $2,000, while the supply price is only $800. If the computer is produced, consumers of computers will gain $2,000 in benefits. In order to produce the computer, society will have to sacrifice $800 worth of other goods and services. It would be possible for those who gain the $2,000 of benefits to reimburse those who lose the $800 of benefits and still be better off. This would result in a net gain of benefits equal to $1,200 ($2,000 $800).
Now suppose the firm is considering producing an additional computer which will expand output to Q2. At Q2, the supply price is $2,000, while the demand price is only $800. If an additional computer is produced there will be a net loss to society of $1,200. This loss implies that resources should be allocated away from computer production. By cutting back on computer output and increasing output in other industries, consumers of computers will lose $800 worth of benefits while others in society will gain $2,000 worth of benefits. Consumers of other goods could reimburse consumers of computers for their loss in benefits and still be better off. Net benefits, and hence efficiency, will increase. At any point where the supply price is greater than the demand price, net benefit can be increased by reallocating resources away from this industry. Such a point is inefficient.
Suppose output is at Q3 where the demand price and supply price are equal. If production were increased, the supply price would exceed the demand price. There is no way to compensate consumers of other goods for the benefits they would forego as resources are allocated to the production of computers. Likewise if production were decreased, the demand price would exceed the supply price. There is no way to compensate consumers of computers for the benefits they would forego as resources are allocated to the production of other goods and services. In both cases, one group in society will benefit and another will be made worse off. Only at the point where the demand price and the supply price are equal will net benefits be maximized and efficiency obtained. Because the demand price equals marginal benefit and the supply price equals marginal cost, equality of the demand and supply prices implies that marginal benefit and marginal cost are equal.
2. If a firm is a pure competitor, marginal revenue and price will be equal. If the firm is a monopoly, marginal revenue will be less than price. Explain these statements.
In order to understand why a pure competitor's marginal revenue is equal to price and why a monopolist's marginal revenue is less than price, recall the following facts. A pure competitor is one of many producers of a homogenous good. She faces a horizontal demand curve. This means that she can sell all the output she wishes at the market price. She is a price taker. A monopolist, on the other hand, is the only producer of a good with no close substitutes. He, in effect, is the industry and faces a downward sloping demand curve. This means that in order to sell additional units of output he must lower the price of the product. The monopolist is a price searcher.