THE WELFARE ECONOMICS OF MARKET POWER

Reference: Jeffrey Church and Roger Ware, Industrial Organization: A Strategic Approach (Irwin
McGraw-Hill, 2000, 1st edition). ISBN: 0071166459.

K.M. Kalebe
NUL, Department of Economics

EC4317
Industrial Organization
 Profit Maximization
• Industrial Organization is about the behaviour of firms in imperfectly
competitive markets. To understand firm behaviour we typically start by
assuming its objective is to maximize profits, which seems reasonable.
• Certainly shareholders want the firm to maximize profits because the
greater the profits, the greater their income.
• How do we find how much a firm interested in maximizing its profits
should produce?
• Suppose that the minimum cost of producing q units of output is given by
C(q) (the cost function). Suppose further that the total revenues of the
firm are determined by the output of the firm and denote this functional
relationship as R(q). Then the relationship between the output of the firm
and its profits, the profit function, is
p(q) = R(q) - C(q)

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 Profit Maximization
• The key to finding the profit-maximizing level of output is to consider the
effect of a change in output on profits. This rate of change is called
marginal profit (MP). Since both revenue and costs change as output
changes, changes in output affect profits.
• The rate of change of revenue with respect to output is called marginal
revenue (MR) and similarly marginal cost (MC) is the change in cost as
output changes.
• Marginal profit is simply the difference between marginal revenue and
marginal cost, or
MP(q) = MR(q) - MC(q).
• If MR > MC, marginal profit is positive—the profits of the firm increase as
it expands its output.
• If MR < MC, marginal profit is negative—the profits of the firm will
increase if it reduces its output.
• When MR = MC, the output level of the firm (q) will be profit maximizing—
profit cannot be increased either by increasing or decreasing q.
• The profit-maximizing rule is that a firm should produce at the output level
q that equates marginal revenue and marginal cost:
MR(q) = MC(q)
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 Perfect Competition
• The four standard assumptions of the perfectly competitive model are
• 1. Economies of scale are small relative to the size of the market. This
means that average costs will rise rapidly if a firm increases output beyond
a relatively small amount. Consequently, in a perfectly competitive
industry there will be a large number of sellers. We also assume that
there are many buyers, each of whom demands only a small percentage
of total demand.
• 2. Output is homogeneous. That is, consumers cannot distinguish
between products produced by different firms.
• 3. Information is perfect. All firms are fully informed about their
production possibilities and consumers are fully aware of their
alternatives.

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 Perfect Competition
• 4. There are no entry or exit barriers. This means that the number of firms
in the industry adjusts over time so that all firms earn zero economic
profits or a competitive rate of return. Why? Because positive and
negative economic profits create incentives for the number of firms in the
industry to change. If economic profits are positive then the revenue of a
firm exceeds the opportunity cost of its factors of production—the value of
the inputs in their next best alternative use. Without entry barriers,
entrepreneurs have an incentive to enter by transferring factors of
production from other industries or activities. And without exit barriers,
negative economic profits mean that firms will exit since their factors of
production can, and will, be profitably transferred to other industries.

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 Perfect Competition
Supply
A single firm
• In this case,
R(q) = pq
So the marginal revenue function of a price-taking firm is simply equal to
price:
MR(q) = p

The profit-maximizing output choice for the firm is:

p = MR(q) = MC(q
• The quantity, q, that equates price and marginal cost is the profit-
maximizing output.

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 Perfect Competition
Market supply
• Market supply is the total amount firms in the industry would
like to sell at the prevailing price.
• For any p, the market supply function gives the output that all
of the firms in the industry would like to supply. Since it is just
a sum, we find the market supply function by summing up the
individual supply functions for each firm.

• The market supply function is

• Where Si(p) is the supply function of firm i, and Qs(p) is the market supply
function.

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 Perfect Competition
Market equilibrium
• The market demand function, Qd(p), is the relationship
between price and total quantity demanded.
• It shows for every possible price the aggregate amount
that all utility-maximizing consumers are willing to
purchase at any price. We find it by summing up the
individual demand curves of all consumers in the market.
• At the equilibrium price both firms and consumers are
able to fulfill their planned or desired trades: firms are
able to sell their profit-maximizing quantities and
consumers are able to purchase their utility-maximizing
quantities.
• So the equilibrium price, Pc, is the price that equates the
quantity supplied with the quantity demanded:

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 Perfect Competition

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 Efficiency
Measures of gains from trade
Consumer surplus
• Consumer surplus is the answer to the question, “How much
would a consumer have to be paid to forego the opportunity to
purchase as much as she wants of a good at a given price?”
• It is the difference between the consumer’s willingness to pay for
another unit of output and the price actually paid.
• The willingness to pay (WTP) for a unit of output is the maximum
amount of money that the individual is willing to forego in order to
consume that unit of output. It is a dollar measure of the
consumption benefit provided by that unit of output.
• If WTP > P, the consumer realizes gains from trade: the benefit
from consuming the unit exceeds how much she has to pay. The
difference between WTP and the actual price paid is the consumer
surplus for that unit: WTP - P.

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 Efficiency
• The optimal consumption level is where the willingness to pay
for another unit equals price. On the last unit consumed,
consumer surplus is zero. Consumer surplus for an individual
from total consumption is a dollar measure of the consumer’s
gain from trading money for the good.
• A consumer will be indifferent between being paid her
consumer surplus and being allowed to consume optimally
the good in question. As optimal or utility-maximizing
consumption depends on price, so too does consumer
surplus.

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 Efficiency
Producer surplus
• Producer surplus is the answer to the question, “How much
would a producer have to be compensated in order to forego
the opportunity to sell as much as she wants at a given
price?”
• It is the difference between the price that firms are willing to
charge and the price that they actually sell at.
• The benefit to a producer from producing in the short run is
given by her quasi-rents. Quasi-rents provide a quantitative
measure of how much better off producers are from trading.
• In the context of the gains from trade, quasi-rents are often
called producer surplus. A firm’s quasi-rents are the difference
between its revenues and total avoidable costs.
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 Efficiency

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 Efficiency

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 Efficiency
Total surplus
• Total surplus is simply the sum of consumer and producer surplus
for a given quantity. On a per-unit basis it is the difference between
consumers’ WTP and the minimum required for it to be supplied by
producers. Recall that WTP is the maximum amount of other goods,
measured in dollars, that consumers are willing to give up for
another unit.
• The quantity of output that maximizes total surplus is where WTP =
MC. This is Q in Figure 2.3.
• Producing units of output greater than Q would decrease total
surplus since MC would exceed WTP on all units greater than Q.
• Producing fewer units than Q would reduce total surplus, since
units for which WTP is greater than MC are not produced, leaving
unexploited gains from trade available.
• Of course, Q is the competitive equilibrium output: market output
in perfectly competitive markets maximizes total surplus and thus is
Pareto optimal.

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 Efficiency
Pareto optimality

• An outcome is Pareto optimal if it is not possible to make one

person better off without making another worse off. So a
move from allocation or outcome A to B that makes someone
better off—a winner—without making someone else worse
off—a loser—is a Pareto improvement.
• An outcome or allocation for which total surplus is maximized
implies that there are no unexploited gains from trade.
• An outcome that maximizes total surplus therefore is Pareto
optimal. A Pareto optimal state is efficient.

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 Efficiency
 There are three well-known problems with assessing efficiency
on the basis of changes in total surplus:
• Consumer surplus is not an exact monetary measure of consumer
welfare. It is, however, a good approximation to the two exact
measures (compensating variation and equivalent variation) if the
income effect is small.
• The basis of consumer and producer surplus is that demand and
supply curves represent not only private benefits and private costs
(which they clearly do), but also capture all social costs and benefits
as well. This will not be the case if there are externalities.
• Distribution of the gains from trade is not explicitly taken into
account when changes in total surplus are used to rank outcomes.
There is an implicit assumption that a dollar of consumer surplus is
identical in value to society as a dollar of producer surplus.

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 Market Power
• A firm has market power if it finds it profitable to raise price
above marginal cost.
• The ability of a firm to profitably raise price above marginal
cost depends on the extent to which consumers can
substitute to other suppliers.
• It is possible to distinguish between supply and demand
substitution.
• Supply side substitution is relevant when products are
homogeneous, whereas demand side substitution is
applicable when products are differentiated.

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 Market Power
Supply Substitution
• The potential for supply substitution depends on the extent to
which consumers can switch to other suppliers of the same
product.
• If consumers cannot substitute to other suppliers capable of
making up all or most of the reduction in its output, a
producer of a homogeneous good will have market power.
Demand Substitution
• The potential for demand substitution depends on the extent
to which other products are acceptable substitutes.
• If products are sufficiently differentiated so that they are not
close substitutes, then some consumers will not substitute to
other products when price rises above marginal cost.

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 Market Power
• A firm with market power is often called a price maker.
• A price maker realizes that its output decision will affect the
price it receives. If they want to sell more, they will have to
lower their price. Conversely, if they decide to sell less, they
can raise their prices.
• The demand curve that a price-making firm faces is downward
sloping. This contrasts sharply with the horizontal demand
curve (at the level of the market price) of a price taker.

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 Market Power and Pricing
• Suppose that you have another cousin who has the exclusive
license to sell alcoholic beverages in Mokhotlong
• Her tavern is called Top of the World (TW).
• If your cousin is interested in maximizing her income, what
price should she charge for her beverages?
• Using the hypothetical case of TW allows us to pursue the
implications of market power when the firm is the sole
supplier or a monopolist.
• A firm is a monopolist if it is not in competition with other
firms.
• A monopolist does not worry about how and whether other
firms will respond to its prices.

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 Market Power and Pricing
• Its profits depend only on the behavior of consumers (as
summarized by the demand function), its cost function (which
accounts for technology and the prices of inputs), and its price
or output.
• A firm will be a monopolist if there are no close substitutes for
its product.

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 Market Power and Pricing
• More formally this means that the cross-price elasticities of demand
between the product of the monopolist and other products are small (and
vice versa).
• The cross-price elasticity e is the percentage change in the quantity
demanded of product i for a percentage change in the price of product j :

• If the cross-price elasticities between the monopolist and other firms are
small, then changes in the price charged by the monopolist will have very
little effect on the demand for the products supplied by other firms.
Hence it is unlikely that they will respond.
• Moreover, if the cross-price elasticity between the other firms and the
monopolist is small the effect of any response on the demand for the
monopolist’s product will be sufficiently trivial that it can be ignored by
the monopolist.

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 Market Power and Pricing

Monopoly pricing
• Back to TW. The profits of TW are p = PQ - C(Q), where
C(Q) is the cost function, P is the price of a pitcher of
beer, and PQ is total revenue.
• TW recognizes that P and Q are not independent. The
feasible combinations for P and Q are given by the
inverse demand function, P = P(Q). This function shows
the maximum price TW can charge consumers and have
them voluntarily purchase Q units of output.
• Substituting it into the definition of profits,we find that
profits depend only on the level of output that the
monopolist selects. The profit function of the monopolist
is

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 Market Power and Pricing
• Now we know that the profit-maximizin output equates
marginal revenue and marginal cost.
• For a competitive firm, firm’s revenue function was simply
R(Q) = PQ.
• Here, however, R(Q) = P(Q)Q.
• Hence marginal revenue is

• To find the profit-maximizing volume of beer, TW should set

its marginal revenue function equal to its marginal cost
function

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 Market Power and Pricing
Inefficiency of monopoly pricing

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 Market Power and Pricing

Exercise question: monopoly pricing with constant marginal

costs and linear demand
Suppose that (i) demand is linear P(Q) = A - bQ, where A and b
are both positive parameters, and (ii) that marginal cost is
constant and equal to c. Find the monopoly price and output,
monopoly profit, deadweight loss and consumer surplus.

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 Market Power and Pricing
Measurement and Determinants of Market Power
• What factors determine the extent of a monopolist’s market
power? Observe that if we factor Pm out of the left-hand side,
we can rewrite

as

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 Market Power and Pricing
• The price elasticity of demand measures the responsiveness
of demand to a change in price. It is
• the percentage change in quantity demanded from a
percentage change in price:

• Substituting the elasticity of demand yields

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 Market Power and Pricing
• Rearranging yields the Lerner index (L):

• which is defined as the ratio of the firm’s profit margin Pm - MC(Qm) and its
price.
• It is a measure of market power since it is increasing in the price distortion
between price and marginal cost.
• It shows that the market power of a firm depends on the elasticity of
demand e. The more elastic demand, the larger e and the smaller the
price distortion. This arises because the greater e, the greater the
reduction in quantity demanded when price rises.
• The key determinant of a firm’s market power therefore is the elasticity of
its demand.
• In considering a monopolist, we did not have to distinguish between the
market demand curve and the demand curve of the firm—they were the
same. However, in general a firm may have market power and not be a
monopolist.

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 Market Power and Pricing
• The extent to which a firm in imperfectly competitive markets can exercise
market power depends on the elasticity of its demand curve.
• The greater the number of competitors (for homogeneous goods) or the
larger the cross-elasticity of demand with the products of other producers
(for differentiated products), the greater the elasticity of the firm’s
demand curve and the less its market power.
 The extent of the inefficiency associated with market power also depends
on the time frame. This is because in the long run, a firm’s elasticity of
demand is likely to be larger for three reasons:
 Consumer Response: Long Run vs. Short Run. The long-run response of
consumers to a price increase is often greater than their short-run
response. For instance, homeowners who use electricity to heat their
homes are unlikely to switch to natural gas, in the short run, when the
price of electricity rises. That switch would require a substantial investment
in natural gas equipment, which may be costly in the shrt run

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 Market Power and Pricing
 New Entrants: If economic profits are positive, then other firms may
try to enter the market. Entry of any magnitude increases the
elasticity of the firm’s perceived demand curve, reducing its market
power. A monopolist may even become a price taker if entry is
sufficiently extensive.
 New Technology: Technological change can generate new products
and services, and the introduction of these products reduces the
market power of producers of established products.
N.B.: These last two factors suggest that the ability of a firm to exercise market power
in the long run will depend on barriers to entry. If entry is easy, then we would not
expect firms to have significant market power in the long run. Entry and competition
from other products (demand side substitution) and other producers (supply side
substitution) will limit, if not eliminate, a firm’s market power if entry barriers are
insignificant. On the other hand, if entry barriers are significant, then a firm will be
able to exercise market power even in the long run.

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 Market Power and Public Policy
• Public policy towards market power takes one of two forms.
• Concerns regarding the inefficiency associated with the
exercise of market power typically result in regulation.
• Regulation involves government intervention to limit the
exercise of market power, typically by constraining or limiting
prices.
• Antitrust laws, on the other hand, are suppose to limit the
acquisition, protection, and extension of market power.
• They do so by making certain kinds of behaviour illegal.
• The economic rationale for determining the legality of
behaviour is to assess its effect on market power.

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 Market Power and Public Policy
• Behaviour that creates, maintains, or enhances market power should be
prohibited because of the deadweight loss from the exercise of market
power.
In the economic approach to determining the legality of a firm’s behaviour we
ask: What are its effects on total surplus? If total surplus declines, the
behaviour should be illegal. If total surplus increases, then there is a
presumption on economic grounds that the behaviour is desirable and should
be legal.
 Consider, for instance, the legality of agreements to fix prices. In the
United States, courts have distinguished between “naked” restraints and
“ancillary” restraints.
 A price-fixing agreement is deemed a naked restraint if the objective and
effect of the agreement are to restrict competition.
 Naked restraints are per se illegal. If firms agree to fix prices, the
agreement is illegal, regardless of the firm’s intentions or the economic
effects of the agreement. The reasoning is based on the belief that firms
enter into such price-fixing agreements to curtail competition, increase
their market power, and charge monopoly prices.

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 Market Power and Public Policy
• Ancillary agreements, on the other hand, are agreements
whose primary purpose and effect are not to fix prices, but to
achieve some other legitimate business objective.
• That is, the fixing of prices is not the main purpose, but
attaining the objective of the agreement requires fixing prices.
• In these cases, the legality of a price-fixing agreement is
subject to a rule of reason approach.
• Under a rule of reason approach it is recognized that certain
aspects of the behaviour might be welfare improving, but for
the agreement not to be an unreasonable restraint of trade,
these aspects must be sufficient to offset the inefficiency
associated with the presumed increase in market power.

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