Part 2 Monopoly Market power and dominant firms Non-linear pricing and price discrimination Market power and product quality
Part 2 Monopoly Market power and dominant firms Non-linear pricing and price discrimination Market power and product quality
Ch 4 Market power and dominant firms Market power-the ability of a firm to profitably raise prices above marginal cost Sources of market power: maintenance of market power requires barriers that prohibit or restrict entry of new firms A dominant firm with a competitive fringe: 2 factors that might limit the ability of a dominant firm to exercise market power are a competitive fringe and the impact of product durability Durable goods monopoly Market power: a second look Benefits of monopol Summar
Ch.4 Market power and dominant firms • Market power-the ability of a firm to profitably raise prices above marginal cost. • Sources of market power: maintenance of market power requires barriers that prohibit or restrict entry of new firms. • A dominant firm with a competitive fringe: 2 factors that might limit the ability of a dominant firm to exercise market power are a competitive fringe and the impact of product durability. • Durable goods monopoly • Market power: a second look • Benefits of monopoly • Summary
Sources of market power( To maximize profits the monopolist produces where marginal revenue equals marginal cost The role of economic profits is to provide a signal regarding the social value of interindustry resource allocation. Positive economic profits in a market indicates that the social value of resources producing that product exceeds their value in their next best alternative use We expect that economic profits will attract entrants: entrepreneurs have an incentive to bid resources away from alternative uses and enter If the new entrants have access to the same technology as the incumbent monopolist we would expect that over time, the incumbents market power would be eroded and eventually eliminated. Entrants provide alternative sources of supply to which consumers can substitute, reducing the profitability of raising price above marginal cost. If entry is easy-there are no barriers to entry-then in the long run market power is eliminated by entry and the equilibrium price pc should equal marginal cost and economic profits will be zero. Market power-when there is not relatively large economies of scale-can only persist in the long run if there are barriers to entry that limit the extent of competition If there are economies of scale then free entry will eliminate economic profits and firms will only be able to exercise sufficient market power to ensure that their economic profits are zero
Sources of market power (1) • To maximize profits, the monopolist produces where marginal revenue equals marginal cost. • The role of economic profits is to provide a signal regarding the social value of interindustry resource allocation. Positive economic profits in a market indicates that the social value of resources producing that product exceeds their value in their next best alternative use. We expect that economic profits will attract entrants: entrepreneurs have an incentive to bid resources away from alternative uses and enter. If the new entrants have access to the same technology as the incumbent monopolist we would expect that, over time, the incumbent’s market power would be eroded and eventually eliminated. Entrants provide alternative sources of supply to which consumers can substitute, reducing the profitability of raising price above marginal cost. If entry is easy-there are no barriers to entry-then in the long run market power is eliminated by entry and the equilibrium price pc should equal marginal cost and economic profits will be zero. Market power-when there is not relatively large economies of scale-can only persist in the long run if there are barriers to entry that limit the extent of competition. If there are economies of scale, then free entry will eliminate economic profits and firms will only be able to exercise sufficient market power to ensure that their economic profits are zero
P=P(Q) MC=AC=C MR(Q Qm Monopoly pricing
Qm Qs MR(Q) P=P(Q) Pc MC=AC=c Pm Monopoly pricing
Sources of market power(2) Entry is impeded when entrants anticipate that their profits postentry will be negative Entry barriers are of interest from 2 perspectives: (1) corporate strategy and ( 2) public policy From the perspective of firms, entry barriers are required to protect an incumbent s market power. However, incumbents will be interested in protecting not only their market power, but also their monopoly profits. A key objective of corporate strategy will be profitable entry deterrence Profitable entry deterrence occurs when incumbent firms are able to earn monopoly profits without attracting entry Profitable entry deterrence depends on the interaction of structural entry barriers and the behavior of incumbents postentry Profitable entry deterrence is not necessarily exogenous-incumbent firms can make strategic investments and engage in other behavior that magnifies the effect of, or creates structural entry barriers and shelters both their market power and monopoly profits From a public policy perspective the existence of entry barriers is also very important. If entry is timely, likely, and sufficient then attempts by firms to exercise or create market power will ultimately be unsuccessful New entry will provide consumers with sufficient substitution alternatives that efforts to raise price above competitive levels will not be sustainable
Sources of market power (2) • Entry is impeded when entrants anticipate that their profits postentry will be negative. • Entry barriers are of interest from 2 perspectives: (1) corporate strategy and (2) public policy. • From the perspective of firms, entry barriers are required to protect an incumbent’s market power. However, incumbents will be interested in protecting not only their market power, but also their monopoly profits. A key objective of corporate strategy will be profitable entry deterrence. • Profitable entry deterrence occurs when incumbent firms are able to earn monopoly profits without attracting entry. Profitable entry deterrence depends on the interaction of structural entry barriers and the behavior of incumbents postentry. Profitable entry deterrence is not necessarily exogenous-incumbent firms can make strategic investments and engage in other behavior that magnifies the effect of, or creates, structural entry barriers and shelters both their market power and monopoly profits. • From a public policy perspective, the existence of entry barriers is also very important. If entry is timely, likely, and sufficient then attempts by firms to exercise or create market power will ultimately be unsuccessful. New entry will provide consumers with sufficient substitution alternatives that efforts to raise price above competitive levels will not be sustainable
Government restrictions on entry 2 kinds of barriers entry barriers created by governments and structural barriers to entr Governments create entry barriers when they grant exclusive rights (monopoly franchise)to produce to the incumbent and use their monopoly on the legal power of coercion to prevent entry by other firms Government grant exclusive franchises for a number of reasons 1. Natural monopoly. Restricting production to a single firm minimizes production costs 2. Source of revenue. governments grant exclusive production rights to create and share in monopoly profits 3. Redistribution rents The government also uses legal restrictions on entry to create and transfer monopoly profits 4. Intellectual property rights. Exclusive rights to produce are also created through intellectual property rights. Governments grant the creators of new ideas (patents )and new expressions of ideas copyrights)protection from imitation and competition by granting innovators intellectual property rights in their creations the extent to which patents and copyrights translate into market power depends on the existence of substitutes
Government restrictions on entry • 2 kinds of barriers: entry barriers created by governments and structural barriers to entry. • Governments create entry barriers when they grant exclusive rights (monopoly franchise) to produce to the incumbent and use their monopoly on the legal power of coercion to prevent entry by other firms. • Government grant exclusive franchises for a number of reasons: • 1. Natural monopoly. Restricting production to a single firm minimizes production costs. • 2. Source of revenue. Governments grant exclusive production rights to create and share in monopoly profits. • 3. Redistribution rents. The government also uses legal restrictions on entry to create and transfer monopoly profits. • 4. Intellectual property rights. Exclusive rights to produce are also created through intellectual property rights. Governments grant the creators of new ideas (patents) and new expressions of ideas (copyrights) protection from imitation and competition by granting innovators intellectual property rights in their creations. The extent to which patents and copyrights translate into market power depends on the existence of substitutes
Structural characteristics(1) Characteristics that reduce the profitability of entry are called entry barriers Entry deterrence requires that an entrant anticipate negative profits postentry An entrants profits postentry will depend on structural characteristics and the nature of competition postentry The natur of competition postentry will clearly be a function of the behavior of the incumbent the more credible threats by incumbent to act aggressively postentry, the lower the entrants profits By credibility we mean that it is profit-maximizing-When faced with actual entry-for the incumbent to behave aggressively either by maintaining production levels or charging low prices The credibility and profitability of aggressive behavior will depend on the structural conditions of the industry
Structural characteristics (1) • Characteristics that reduce the profitability of entry are called entry barriers. • Entry deterrence requires that an entrant anticipate negative profits postentry. • An entrant’s profits postentry will depend on structural characteristics and the nature of competition postentry. • The natur of competition postentry will clearly be a function of the behavior of the incumbent. The more credible threats by incumbent to act aggressively postentry, the lower the entrant’s profits. By credibility we mean that it is profit-maximizing-when faced with actual entry-for the incumbent to behave aggressively either by maintaining production levels or charging low prices. • The credibility and profitability of aggressive behavior will depend on the structural conditions of the industry
Structural characteristics(2) The 4 structural characteristics that are often thought to be entry barriers are 1. Economies of scale If economies of scale are extensive then in order to enter on a cost competitive basis, a new entrant requires significant market share This is likely to depress prices and make it more likely that entry is not profitable. Entering on a small scale will have a relatively small effect on price, but the entrant s average costs will then be relatively high, again contributing to negative postentry profits 2. Sunk expenditures of the entrant To the extent that the investments required for entry are sunk, entrants might be reluctant to enter if they anticipate that these expenditures wil not be recovered. Sunk investments mean that any remaining investment is not recoverable upon exit from the market Many sunk expenditures are fixed costs which also are responsible for economies of scale
Structural characteristics (2) • The 4 structural characteristics that are often thought to be entry barriers are: • 1. Economies of scale. • If economies of scale are extensive, then in order to enter on a cost competitive basis, a new entrant requires significant market share. This is likely to depress prices and make it more likely that entry is not profitable. Entering on a small scale will have a relatively small effect on price, but the entrant’s average costs will then be relatively high, again contributing to negative postentry profits. • 2. Sunk expenditures of the entrant. • To the extent that the investments required for entry are sunk, entrants might be reluctant to enter if they anticipate that these expenditures wil not be recovered. Sunk investments mean that any remaining investment is not recoverable upon exit from the market. Many sunk expenditures are fixed costs which also are responsible for economies of scale
Structural characteristics (3 3. Absolute cost advantages It may be the case that the incumbent firm has lower costs of production than potential entrants: at any common scale of operation the average cost of the entrant exceeds the average cost of the incumbent Fundamentally, the source of such an advantage must be that the entrant is denied access to, or pays a higher price for, some factors of production An absolute cost disadvantage puts the entrant at a competitive disadvantage, and in the limit the monopoly price of the incumbent may be less than the minimum average cost of the entrant: the result, possibly in the former, and certainly in the latter is entry deterrence Ownership of a superior ore mine or a key patent appears to provide an incumbent with an absolute cost advantage and therefore is a potential entry barrier
Structural characteristics (3) • 3. Absolute cost advantages. • It may be the case that the incumbent firm has lower costs of production than potential entrants: at any common scale of operation, the average cost of the entrant exceeds the average cost of the incumbent. • Fundamentally, the source of such an advantage must be that the entrant is denied access to, or pays a higher price for, some factors of production. • An absolute cost disadvantage puts the entrant at a competitive disadvantage, and in the limit the monopoly price of the incumbent may be less than the minimum average cost of the entrant: the result, possibly in the former, and certainly in the latter, is entry deterrence. • Ownership of a superior ore mine or a key patent appears to provide an incumbent with an absolute cost advantage and therefore is a potential entry barrier
Structural characteristics(4) Demsetz(1982)observed that care must be taken to ensure that an absolute cost advantage-and the implied barrier to entry-does not disappear when the assets of the firm are valued at their opportunity cost If assets are tradable, then instead of using the asset, the incumbent could sell out to a potential entrant. the rents created by this factor are an opportunity cost to the incumbent. If the asset were traded, the rents created by the asset would become capitalized in its price. The guestionthen becomes, however, whether the capitalized rents are Ricardian rents or monopoly rents(profits) In competitive markets the price is determined by the least efficient producer in the market: the marginal cost of the last unit(highest cost) supplied equals the price. Firms with lower costs earn Ricardian rents those rents are not economic profits. Rather they are a return to their superior factors of production; the market value of these factors would include these capitalized rents and a decision to use them rather than sell them requires an imputation of their opportunity cost, namely, their market value. In doing so the firm s economic profits become zero; the apparent economic profits of the firm arise from the scarcity and superiority of the factor of production, not from anything done by the firm On the other hand access to a superior factor of production may provide a firm with market power this will be the case if the scale of production at which the cost advantage is sustained is large enough that the firm can act as a price maker
Structural characteristics (4) • Demsetz (1982) observed that care must be taken to ensure that an absolute cost advantage-and the implied barrier to entry-does not disappear when the assets of the firm are valued at their opportunity cost. If assets are tradable, then instead of using the asset, the incumbent could sell out to a potential entrant. The rents created by this factor are an opportunity cost to the incumbent. If the asset were traded, the rents created by the asset would become capitalized in its price. The questionthen becomes, however, whether the capitalized rents are Ricardian rents or monopoly rents (profits). • In competitive markets the price is determined by the least efficient producer in the market: the marginal cost of the last unit (highest cost) supplied equals the price. Firms with lower costs earn Ricardian rents: those rents are not economic profits. Rather they are a return to their superior factors of production; the market value of these factors would include these capitalized rents, and a decision to use them rather than sell them requires an imputation of their opportunity cost, namely, their market value. In doing so the firm’s economic profits become zero; the apparent economic profits of the firm arise from the scarcity and superiority of the factor of production, not from anything done by the firm. • On the other hand access to a superior factor of production may provide a firm with market power. This will be the case if the scale of production at which the cost advantage is sustained is large enough that the firm can act as a price maker