The economics of market power

The theory of monopoly

    All firms seek to obtain, consolidate and expand market power. Many firms have

some degree of market power but, in the majority of cases, it is not sufficient to

cause significant deviations from a competitive market outcome. Other firms

occupy strong monopoly positions. Firms in this category account for a significant,

if not strictly determinable, proportion of total marketed activity. To understand

the market system in its entirety, therefore, we need to know how the

system functions when individual firms possess significant market power.

Specifically, we need to know the consequences of this power for the firm’s

price and output decisions, how market power is attained and sustained,

the systemic implications of market power, and how policy-makers should

respond to it. We discuss the first two issues in this chapter and the others in

Chapter 7.

    The consequences of market power can be explained with the analysis of the

firm described in Chapter 5. For simplicity, we take the extreme case of a singleproduct monopoly. We assume its costs are U-shaped .Demand conditions

are represented by the demand curve DD, from which the marginal revenue

curve MR can be derived. Applying the profit-maximisation rule MR # MC gives

the equilibrium output of OQ_m. The market-clearing price for that output is OP_m.

The average cost at that output level is SQ_m. Monopoly profits are then the average profit margin RS multiplied by output OQ_m. They are represented by the area of the rectangle P_m_RSF.

    Market power means that an individual firm’s output affects price. Thus,

suppose production were raised above OQ_m to OQ,. Price would have to fall to

OP,. Corresponding to that price and output, we have MC # Q,S, and MR # Q,T,.

Note that MR ` MC. This implies that the net increase in revenue obtained by

raising output by Q_m_Q, is less than the cost of producing that extra output. Hence

total profits must be lower at output OQ, than at OQ_m. The profit-maximising

monopolist, therefore, will cut back sales to OQ_m. The profit-maximising rule prevents the firm from selling either more or less than OQ_m. This is why Q_m and P_m are monopoly equilibrium price and quantity.

    The economic consequences of the monopoly are estimated by reference to the

benchmark case of competition We start off from the monopoly equilibrium. Only this time, for convenience of exposition, constant costs over the relevant output span are assumed .The monopoly sells OQ_m at price OP_m. Now assume that competition is introduced into the industry. Each plant is taken over by an independent owner. The plants are numerous, so each single owner can have no influence on price. Hence, MR # P for each individual firm. The profit-maximising rule leads each firm to produce up to the point where P # MR # MC. In Figure 6.2, this corresponds to point S, with output OQ_c   and price OP_c .The welfare loss of monopoly is the triangular area RTS. Intuitively, this represents the total utility derived from the addition of Q_m_Q_c to extra output, measured by Q_m_RSQ_c less the actual resource cost of producing it represented by the area under the MC curve, Q_m_TSQ_c. The creation of this so-called ‘dead-weight’ loss of monopoly constitutes the standard ‘static’ argument against monopoly.