when an economist refers to a decision as rational, they mean that it represents an individual choosing the option which maximizes their well being, considering the relevant costs. There are few constraints on what contributes to the well being of a rational individual, only that it is consistent with their personal preferences
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Do sellers in the same market sell products which are identical?
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How many sellers exist in the market?
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In essence, in the presence of differentiated products, consumer preferences allow for a consumer to be willing to pay more for one firm’s product than another firm’s product. If a consumer is willing to pay $800 for the United flight instead of $750 for the Delta flight, then clearly the products are different. (Why pay an extra $50 for something identical?) Moreover, the willingness to pay more for the United flight must be driven by some preference for what United offers, like better customer service. Product differentiation creates markets where differences in preferences gives consumers different WTP for goods from different sellers in the same market.
The second question focuses on the number of sellers in the market. 1 Instead of identifying an exact number of sellers in a given market, though, market structure categorization will rely on whether markets have many sellers, few sellers, or one seller. Despite how imprecise these terms seem, they provide us with more than enough information for us to apply the relevant market structure model in our analysis.
So, how many is “many”? Or “few”? The number of sellers that exist in a given market is determined by how easily new firms can enter the market. Barriers to entry are conditions which would prevent at least some firms from entering a particular market. While some barriers to entry can be strategic – the result of specific actions taken by a firm already in the market to keep other firms out of the market – we will focus on structural barriers to entry. These are conditions inherent in the nature of the particular market that can make it difficult or impossible for new firms to enter that market. 2
Structural barriers to entry can arise under several different conditions:
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access to necessary resources: A firm can be prevented from entering a market if it does not have access to some essential input. To enter the market for diamonds, a firm would need to own a diamond mine! To compete in the market for beachfront restaurants, the restaurant would need property near the beach! If essential inputs are scarce, barriers to entry are likely to exist. 3
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legal barriers: Legal barriers to entry are protections under the law, such as patents, trademarks, and licenses, which prevent sellers from entering markets. Since Apple has a patent on the iPhone, other sellers are prohibited from producing and selling iPhones. Some sellers needs licenses from the government to operate: taxis (taxi medallions), bars (liquor licenses), doctors (medical licenses), and even hairdressers.
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cost: ???
Cost is an interesting one to consider. There are certain markets where the cost of entering the market is so wildly high that no firm would find it rational to enter. These markets are known as natural monopolies, where due to the excessively high cost, the market logically has just one seller. The most common example would be a public utility, such as public water. In most cities, water is provided by the city government. But imagine how a firm would go about entering the market: it would need rights to a very large source of water, and would need to dig up the entire city, lay its own pipes everywhere, and connect them to every home and business. Incredibly disruptive and incredibly expensive! 4 5
In other industries, the cost to entering may be very high, but not technically so high that firms would never reasonably enter. In markets like these, high costs serve as a kind of soft barrier to entry: it serves to deter much entry, but is not an absolute dealbreaker. Consider the automotive industry. Is it very high cost to start a car manufacturing company? Without a doubt. Is it impossible to do? Not necessarily. While some manufacturers have existed for nearly 100 years, others – such as Tesla, which was founded in 2003 – have been able to make the large investment to start a new one.
The presence of barriers to entry is closely related to the number of sellers in a given market. Markets with strict barriers to entry, such as natural monopolies or markets where production is protected by a patent, are likely to have just one seller. Markets with soft barriers to entry, like high-but-not-excessively-high costs, will likely have a small number of firms: the barriers will not keep out all entrants, but it will deter entry enough to keep the number of sellers low. A market with few significant barriers to entry, or no barriers to entry at all, is likely to be a market with many sellers. The market for coffee shops, for example, may have some small regulations that need to be met (such as meeting public health codes), but these are not likely to deter an entrepreneur from entering the market.
Based on these two factors – number of sellers and degree of differentiated products – the grid below categorizes four crticial market structures. Along the top of the grid, market structures are characterized by the number of firms and, consequently, the barriers to entry. Along the left side, the grid plots identical versus differentiated products. While these four market structures do not encompass all markets, they serve both as important descriptive models of the world and as helpful benchmarks for markets which do not fit squarely into the grid.
three characterizations of market power. Each one gives an equivalent description of how market power presents. The first, MP1, is below:-
MP1: A seller with market power can influence the price for which it sells in the market. A buyer with market power can influence the price he pays in the market.
Simply put, market power is about ability to influence price. This power is generally good for the actor who has it: a seller with market power can use that power to ask for a higher price for the good or service it sells, while a buyer with market power can use that power to pay a lower price for a purchase.
An actor without market power has no ability to influence the price they ask for or pay. Consider walking into a supermarket to purchase an avocado. Would you be able to negotiate the price with the cashier or manager? “Hi, I know this avocado is priced at $1.50, but I’d like to pay $0.75 for it.” This likely wouldn’t go well! Most buyers don’t have market power, because in most markets, there are a large enough number of buyers that no buyer could influence the price. Since sellers have enough other buyers to sell to, no single buyer has any leverage to change the price.
Market power can arise in markets where there are a small number of actors. As a single seller in the market, a monopoly has market power; similarly, firms in oligopolistic competition have market power. Buyers have fewer alternatives to turn to with so few sellers, so the higher-than-otherwise price can be sustained. Market power does not mean that firms in these markets can charge whatever price they want. Rather, very simply, it means that these firms have influence over the price.
What about markets with many firms? Monopolistically competitive firms do have market power, despite the abundance of firms. In these markets, market power arises because of the differentiated products across firms. Since firms sell products that are slightly unique, this uniqueness allows the firms to maintain a bit of influence over their price. When a monopolistically competitive firm sells its differentiated product, since there are consumers who have a preference for this product, the firm can ask for a higher price. This market power may not be as strong as in oligopolies or monopolies, but it exists.
In perfectly competitive markets, however, there are many firms and all products are identical! Therefore, firms have no basis for asking for a higher price for its goods. There are a large number of competitors, all selling products that are identical, so if one firm asks for a higher prices, buyers can simply seek out a competitor selling the same good at the lower price. Perfectly competitive firms have no market power. Often, we say perfectly competitive firms are price-takers, suggesting that without any capacity to influence the price, firms must take the price in the market as given. Below, we see the market structure grid from above, highlighting which firms have market power. Firms in monopoly, oligopoly, and monopolistic competition all have market power. Firms in perfect competition are actually the exception: this is the only primary market structure where firms lack market power. This makes perfectly competitive markets fairly unique.
(barriers to entry) (soft barriers) (no barriers) one firm few firms many firms identical products ↑ ↑ perfect competition𝑋 monopoly✓ oligopoly✓ differentiated products ↓ ↓ monopolistic competition✓ Common market structures showing market power. Market structures where firms have market power are denoted with a blue checkmark (\checkmark), while in perfect competition, the lack of market power is denoted with a red X (X).
So, what are the consequences of a seller having market power? Why does it matter to have influence over the price?
Price matters because it influences how many units of a good consumers will demand. Therefore, a firm with market power (who can therefore influence price) can also influence the number of units of its product demanded. In chapter 1, we introduced the notion of residual demand, which is the demand faced by the firm. With residual demand, we view the demand relationship – how many units are demanded at a given price – from the firm’s perspective. Since for the moment, our focus is firm market power, residual demand is where the impact of that marker power will be felt.
The second definition of market power directly captures this influence:
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MP2: A firm with market power faces a downward-sloping residual demand curve. A firm with NO market power faces a horizontal residual demand curve. 1
We say a firm with market power faces a downward-sloping demand function, such as ,𝑄𝐷=200−10𝑃, because a change in firm price causes a change in the number of units demanded by consumers. A firm facing 𝑄𝐷=200−10𝑃 knows that if it charges a price of 12, consumers will demand 80 units. The firm also knows that if it increases its price to 15, consumers will demand only 50 units.
The downward-sloping nature of residual demand here captures a tradeoff, the inverse relationship between price and quantity for the firm. A firm with market power can use its market power to raise price, but since it has market power, the price increase will result in a lower quantity demanded. Conversely, a firm with market power could consider selling higher quantity of output, but in order to increase the quantity sold, the firm would have to lower its price. This tradeoff shows the double-edged nature of market power. A firm with market power does have the ability to increase price, but when it does so, it will lose customers; if it increases its price too far, it will surely have an unambiguously negative impact on its revenue. 2 Along the same lines, a firm with market power has a weak incentive to produce a high quantity, since selling a higher quantity necessitates a price decrease and undermines firm revenue.
This can be captured in the algebraic expression for total revenue, using inverse demand. Recall that when demand is ,𝑄𝐷=200−10𝑃, inverse demand is .𝑃=20−110𝑄𝐷. While demand can be interpreted by the firm thinking “at a price of 12, consumers will demand 80 units,” inverse demand can be interpreted by the firm thinking “if my objective is to sell 80 units, the highest price I could charge to sell 80 units is a price of 12.” Plugging a target 𝑄𝐷 into inverse demand gives the highest price which would still yield that quantity.
We know total revenue is price × quantity. When a firm has market power, and can influence its price, price is given by the inverse demand function, ,𝑃=𝑃(𝑄), since the price a firm will ultimately charge depends directly on the number of units it wants to produce, and therefore price is a function of quantity! Total revenue can then be expressed as .𝑇𝑅=𝑃(𝑄)×𝑄. With the numerical example above, .𝑇𝑅=(20−110𝑄)𝑄=20𝑄−110𝑄2. The upside-down U-shaped total revenue curve (as seen below) equivalently captures the price-quantity tradeoff, the double-edged nature of firm market power.
Figure 4.2.1. Market power story. Downward-sloping residual demand leads to an upside-down U-shaped TR curve. As 𝑄 grows, total revenue areas get larger, peak, then get smaller.
If a firm operates in a perfectly competitive market and has no market power, it cannot influence the price it can charge. By contrast, then, when this firm generates revenue ,𝑇𝑅=𝑃×𝑄, this price 𝑃 is a constant! If the price in a perfectly competitive market is ,𝑃=20, then whether any individual firm produces 2 units of output or 200 units of output, the price does not change. Therefore, it stays constant in the firm’s total revenue calculation. At a price of 20, for example, total revenue can then be written as .𝑇𝑅=𝑃𝑄=20𝑄.
This lack of market power has two impacts on the shape of the firm’s problem. First, since the price cannot change in response to a change in quantity from a firm, then each firm in a competitive market faces a demand that is horizontal. It is flat, suggesting that the price remains unchanged at any quantity. 3 While a flat demand curve seems odd, remember that this is the residual demand curve for a firm: the way demand looks from the perspective of the firm. The demand for all consumers in the market is still likely to have its typical downward-sloping shape.
Figure 4.2.2. No market power story. Horizontal residual demand leads to a linear and increasing TR curve. As 𝑄 grows, total revenue areas grow indefinitely.
Second, the lack of market power nullifies the tradeoff between price and quantity firms with market power must make. As a competitive firm increases the number of units it wants to sell, the price does not change. Therefore, there is no negative impact on revenue resulting from a price decrease! A s a result, a competitive firm has a strong incentive to increase output. This can be observed in the shape of the competitive firm’s total revenue function, which is linear (,𝑇𝑅=20𝑄, for example) and grows continuously. Notice as well that total revenue can still be visualized on the graph of the firm’s residual demand curve as the area under the curve at a given point, since ,𝑇𝑅=𝑃×𝑄, and the coordinates of any point are its price and quantity. It is clear that as the firm increases production, this area – and the firm’s revenue – gets infinitely large. 4
Figure 4.2.3. Horizontal residual demand at a price of 10. If ,𝑄=20, TR is 200. If ,𝑄=21, TR grows to 210. Since demand is horizontal, TR rectangles grow larger and larger.
We recap the comparison of market power and no market power in the table below. Market power manifests itself in many ways. Importantly, this distinction is critical in understanding both how firms behave to maximize profit, and how this behavior influences outcomes, in different market structures. We will study profit maximization and market interactions in perfect competition in the next chapter. This will serve as our initial benchmark, against which we will compare behavior in the presence of market power.
no market power (competitive) market power (monopolistic/oligopolistic) MP1 cannot influence price can influence price price firm treats as constant firm treats as a function of quantity price expression 𝑃 – a number 𝑃(𝑄) – inverse demand function MP2 faces horizontal residual demand faces downward-sloping residual demand output incentives strong incentive to increase output weak incentive to increase output total revenue 𝑇𝑅=𝑃𝑄 𝑇𝑅=𝑃(𝑄)×𝑄 total revenue shape linear and increasing upside-down U-shaped Comparison of market structures where firms have NO market power, such as perfect competition (left column), and market structures where firm HAVE market power (right column), such as monopoly, oligopoly, and monopolistic competition.
In Depth 4.2.4. Perfect competition as a special case.
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MP1: A seller with market power can influence the price for which it sells in the market.
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MP2: A firm with market power faces a downward-sloping residual demand curve. A firm with NO market power faces a horizontal residual demand curve.
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MP3: A firm with market power can charge a price above its marginal cost. A firm with NO market power charges a price equal to its marginal cost.
Firms with market power can influence their price, which allows firms to charge a price above their marginal cost. Market power manifests itself as a downward-sloping demand curve faced by the seller, since at different prices, consumers will demand different quantities of their product.
We have seen that market power can have several origins. If there are barriers to entry in a given market, this could reduce the number of sellers, and give existing sellers market power. Market power can also arise if a firm produces a differentiated product: even if there are many sellers in a market, consumers will be responsive to price changes for a unique product, and the firm can maintain its influence over the price.
It is important to remember that market power forces the firm to make a tradeoff. Since a firm with market power faces a downward-sloping demand curve, if the firm tries to increase its quantity, it must lower its price; this tradeoff (price must ↓ to get quantity ↑) undercuts the firm’s revenue, and gives the firm a weak incentive to produce high levels of output – or conversely, a strong incentive to limit output.
Figure7.1.1.A recap of the market power story. Downward-sloping residual demand leads to an upside-down U-shaped TR curve. As 𝑄 grows, total revenue gets larger, peaks, then gets smaller.
Marginal analysis shows (Section 3.4) that any firm will maximize its profit by choosing a level of output 𝑞∗ where its marginal revenue (𝑀𝑅) equals its marginal cost (𝑀𝐶). That is, at ,𝑞∗,
We can observe this with our current toolkit by simultaneously graphing the firm’s total revenue and total cost:
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Any firm will have an increasing and convex total cost function under assumption P2;
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A firm with market power will have an upside-down U-shaped total revenue function (see the end of Chapter 1).
Since marginal revenue is the slope of total revenue curve, and marginal cost is the slope of the total cost curve, the profit-maximizing quantity of output occurs where the two curves have the same slope. This corresponds to where the distance between 𝑇𝑅 and 𝑇𝐶 is the greatest, since, by definition, profit is this difference: .𝜋=𝑇𝑅−𝑇𝐶.
Figure7.1.2.Total revenue, total cost, and profit for a firm with market power. At the profit-maximizing quantity of output, the slopes of 𝑇𝐶 and 𝑇𝑅 are identical, as it maximizes distance between the two curves.
Just as we saw in perfect competition 1 , it is very useful to be able to visualize optimal output on a graph showing marginal revenue and marginal cost. This will take a little bit of work, though.
Unlike in perfect competition, where the marginal revenue is equal to the price, marginal revenue is not equal to the price for a firm with market power. Remember why this happens. For a competitive firm who cannot influence the price, each additional unit sold will generate exactly 𝑃 dollars, so each additional unit sold must generate exactly 𝑃 dollars of revenue. Therefore, 𝑀𝑅=𝑃 must be true in perfect competition.
For each additional unit sold by a firm with market power, the price decreases. This is the tradeoff, the double-edged nature of market power we just discussed! But notice: when the price decreases, the firm collects a lower price for every unit sold! This significantly undercuts the added revenue from the additional unit, and weakens marginal revenue. As a result, it must be true 2 that
Numerically, for example, if the price of a good is ,𝑃=10, then an additional unit sold by a firm with market power will not generate 10 dollars of added revenue. This is because the price will need to decrease (below 10) to sell the additional unit, and the firm will collect less than dollars from all units now sold. Even if the price drops to 9.90, collecting 9.90 instead of 10 dollars from each unit sold may lead to the firm only collecting, say, 6 dollars of added revenue. As a result, the nature of market power keeps marginal revenue below the price.
This syncs up with incentives for firms with market power. We know that a firm with market power has a weak incentive to increases its output, since price will drop. A lower marginal revenue reinforces the weakness of this incentive: since additional units of output are not generating as much revenue, the firm with market power will not find increasing output as appealing.
Therefore, marginal revenue must be less than the price for a firm with market power. To see exactly how marginal revenue and price compare, therefore, we turn back to the downward-sloping demand faced by the firm (MP2). First, price comes from the demand faced by the firm: by definition, since the demand curve gives the relationship between price and quantity, it will give us the highest price the firm can charge to sell any desired quantity of output.
What about marginal revenue? By definition, marginal revenue is the change in total revenue given a change in output, and can be seen as the slope of total revenue. But total revenue is an upside-down U-shaped curve for a firm with market power! This means 1) for low levels of output, MR is positive; 2) for high levels of output, MR is negative; 3) at some level of output in between, MR is zero.
This conclusion is consistent with how market power affects marginal revenue. We know that increases in output will force the firm to lower its price, eroding the added revenue generated by the output increase. At low level of output, the added unit of output will increase TR, and MR will be positive:
As the firm produces more and more output, however, the price gets lower and lower. This amplifies the price tradeoff the firm must make when it produces more output. If adding another unit of output lowers the price which can be charged on a high number of units, the tradeoff is more damaging to TR. In particular, if the firm produces a unit on the right side of TR (beyond the peak of the curve), that added unit actually decreases total revenue! The price decrease entirely offsets any revenue gains from selling another unit.
This has an important implication for market power profit maximization. A firm with market power will never want to choose a quantity on the right side of the peak! If producing an additional unit decreases revenue (negative 𝑀𝑅) and increases cost (assumption P1), this unit cannot ever be optimal. Why produce a unit that will add to your cost and lose you revenue?
So marginal revenue starts off positive, hits zero, then becomes negative. This suggests that marginal revenue is decreasing, which makes sense: the slope of TR decreases as 𝑞 increases. 3 We can then draw marginal revenue as a decreasing function which cuts through the x-axis and goes negative for high values of output. 4
Figure7.1.3.Left: With market power, the firm’s total revenue curve is upside-down U-shaped. First, slope is positive, then zero at its peak, then negative on the far right. Right: Marginal revenue is slope of total revenue. First, 𝑀𝑅 is positive, then zero when corresponding to peak ,𝑇𝑅, then negative to the far right.
But we have also shown that marginal revenue must be less than the price. Therefore, while demand and marginal revenue are both decreasing functions, marginal revenue must lie below demand.
Figure7.1.4.Demand and its corresponding marginal revenue.
In a numerical example we saw earlier, a firm with market power faces demand curve .𝑄𝐷=200−10𝑃. This corresponds to an inverse demand curve of .𝑃=20−110𝑄. We know the firm’s marginal revenue curve must be below the demand curve, and in this example, the firm’s marginal revenue is .𝑀𝑅=20−15𝑄. To interpret, if the firm would like to sell 𝑄=80 units of output, then
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from the inverse demand, we know the firm will be able to charge a price of ;𝑃=20−(110)(80)=12;
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from the marginal revenue, the added revenue of the last unit of output for the firm is .𝑀𝑅=20−(15)(80)=4.
These calculations are consistent with the 𝑀𝑅<𝑃 result from earlier. Even though the 80𝑡ℎ unit of output sells for a price of 12, it will only generate 4 dollars of additional revenue for the firm, as the price decrease to 12 erodes revenue gains from the other 79 units.
One last point: the equation for marginal revenue here does not appear from thin air. In fact, there is a simple rule for determining the marginal revenue equation in cases where inverse demand is linear:
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When inverse demand is linear, the firm’s marginal revenue curve will have (1) the same y-intercept as inverse demand, and (2) twice the slope of the inverse demand function.
With inverse demand ,𝑃=20−110𝑄, we then know the marginal revenue curve will also have y-intercept of 20, and a slope twice as steep as ,110, which is .15. This gives the full equation .𝑀𝑅=20−15𝑄. The “twice as steep” rule guarantees that marginal revenue lies below the demand curve. 5
Figure7.1.5.Demand and marginal revenue. When inverse demand is ,𝑃=20−110𝑞, marginal revenue is .𝑀𝑅=20−15𝑞. At 𝑞=80 units, the firm will charge a price of ,𝑃=20−110(80)=12, while the last unit sold generates added revenue of .𝑀𝑅=20−15(80)=4.