Degrees of Market Power and Policy

April 12, 2013

Announcements

• Problem Set 2 due Monday!• TAs will go over in section next week.

Last Class

• Studied how to derive monopoly profits in-depth.– Find Q using MR and MC– Calculate profits using ATC

Learning Goals for Today

• Show how price discriminating monopoly surplus differs from generic monopolies.

• Describe how oligopoly and monopolistic competition differ from monopoly.

• Offer policy recommendations for dealing with monopolies.

Recall: General Form of Monopoly Problems

• Given:– Fixed Costs– Production Function: Generally Q=KaL1-a

– Variable Costs: w for L and r for K– Demand

• Derive:– TC, ATC, MC given Fixed Costs, Prod Func, and Var

costs– MR given Demand– Profit-max. condition and Profit given the above– Surplus

Price Discrimination• Thus far we have assumed all buyers charged the same.• Price Discrimination: The practice of charging different buyers

different prices for essentially the same good.• How does price discrimination affect output and profits?

P P

Q Q

D D

MC=ATC

MR

MC=ATC PS

DWL

CS

Single-Price MonopolistPerfectly Price

Discriminating Monopolist

PS

Example: ``Hurdle.’’

• Rebates: The assumption is that people with high reservation prices are wealthy and that the opportunity cost of their time is too high to be bothered to fill out the paperwork to get the rebate.

Which of the following is price discrimination?

A. EfficientB. GoodC. InefficientD. BadE. Can’t Say

Other types of firms with market power

• Are there firms that have some, but not complete market power?

• Think in terms of the assumptions we made for perfect competition. Which are violated under what conditions?– All firms sell the same (really the same!) product.– There are many buyers and sellers.– There are no costly barriers to starting a business.– Both consumers and firms are well-informed.

Monopolistic Competition

Examples?

Have some ability to raise price in the short-run, but free entry will lead to zero (economic) profits in the long run.

Most important strategic decision: how to differentiate products from rivals’ products?

Markup

A market in which a large number of firms sell products that are close (but not perfect) substitutes.

Oligopoly

Examples?

Usually arise because of cost advantages of being large—thus, no presumption that free entry will drive profits to zero, but no guarantee that oligopolists will earn zero profits.

A market in which a small number of large firms sell products that are either close or perfect substitutes.

Consider two oligopolists. If one is charging the price a monopoly would choose, the other should charge which of the following to

profit-maximize?

A. A higher PB. The same PC. A lower P

Government Regulation

• When we think about government regulation, we primarily think about regulation of natural monopolies. Why?

• Five sources of market power1. Exclusive control of inputs2. Patents and copyrights3. Government licenses4. Economies of Scale5. Network Economies

Can sometimes be thought of as the same thing—both give rise to natural monopolies

Government Regulation

• State ownership of natural monopolies.– Only one private company can survive—average costs are

too high when multiple firms are in the market.– Solution: government takes over, sets P=MC and then

absorbs any loss (paid for by taxes).– Potential problems:

• Will government-run firm be cost efficient?• Where do tax revenues come from?

Government Regulation

• State regulation of natural monopolies (common in the U.S.).– Most states regulate electric utilities, natural gas providers,

and cable television companies.– Cost-plus regulation: figure out the monopolists explicit

costs and then allow them to charge that plus some markup.

– Problems 1. Often difficult to determine a firm’s costs 2. Blunts firm’s incentive to cut costs.

Government Regulation

• Allow private firms to bid for the right to provide the goods and services that would be provided by a natural monopoly.– Competition maintains firms’ incentives to cut costs.– Problems: may not be feasible in cases where production

requires a large fixed investment in capital equipment—how do you transfer the equipment if another firm wins the bid?

– Many cities increasing considering or using private contractors to provide garbage collection, fire protection, police protection, EMS, landscaping etc.

Ignore Monopolies?

• Price discrimination implies that monopolists are making much of their profit from buyers who are willing and able to pay higher prices.

• Much of monopolists’ profits goes to the federal government via the corporate income tax, and this money can be used to fund a variety of government programs.

• On the other hand, imperfect price discrimination will not lead to an efficient outcome—so we still need to be concerned.

For next time

• Finish problem set• Try to grasp Nash equilibria from the reading• We will begin with oligopolist game