SUBJECT:
Economics
LEVEL:
course preparation
TOPIC:
(10) Market power,
based on Oxford CP
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The lack of any market power by perfectly competitive firms leads to low prices for
consumers and to allocative efficiency. In the real world though, most firms do have some
degree of market power. Prices are therefore often, but not always, higher. Large firms
may enjoy economies of scale as a result of their size and may invest in R&D, which leads
to innovations. But when firms abuse their market power and eliminate competitors or
block entry of new firms, then welfare decreases.
Economic costs and profits
PROFITS (π) are defined as the difference between the total revenues (TR) collected and the
total costs (TC) of production:
π = TR − TC
ECONOMIC COSTS include the value of all resources employed and which are therefore
sacrificed, whether the firm makes a payment or not.
EXPLICIT COSTS are direct payments made to others in the course of running a business.
They have clearly defined dollar amounts and appear in the general ledger and the income
statement. They directly affect a company's profitabillity. Examples of explicit costs include
wages, rent, utilities, raw materials, and other direct costs.
IMPLICIT COSTS are non-monetary opportunity costs that arises when a firm uses a factor of
production for which it already owns and does not pay rent. An implicit cost is not shown or
reported as a seperate expense, but it represents what a firm must give up in order to use
its internal resources.
Entrepreneurial capital is also scarce, since it refers to funds that if used in one business, are
automatically not available for use in another. The minimum return is equal to what the
capital owner have been earning in the next best alternative with the same risk.
NORMAL PROFIT is an economic term that describes a situation where a company's total
revenues are equal to its total costs, including both the explicit and implicit costs of
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production. It means that the company is earning enough to cover its opportunity cost of
uses its resources effectively and maintaing a competitive edge in its industry. Normal profit
is also known as the break-even point or zero economic profit.
SUPERNORMAL PROFITS are all the excess profits a firm makes above the minimum return
necessary to keep a firm in business.
ECONOMIC LOSS is the situation when a firm delivers not enough income to equal all its
economic costs including minimum return necesary to cover the cost of capital resources.
How much output should a firm choose to produce in order to maximize prots?
As long as the additional revenue from producing and selling one more unit is bigger than
the additional cost incurred to produce it, the firm should keep on producing more and
more units per period because its profits will be increasing. Profits will be maximized when,
for the last unit produced, MR = MC.
Products and markets
Amidst others, we can distinguish the following two broad types of products:
A. HOMOGENEOUS PRODUCTS are products that consumers consider perfect
substitutes (identical).
B. DIFFERENTIATED PRODUCTS are products consumers consider close but not perfect
substitutes.
We can distinct the following types of markets:
A. PERFECTLY COMPETITIVE markets have very many small firms, selling a
homogeneous product and there’s nothing to prevent entry of new firms into the
market.
B. MONOPOLISTICALLY COMPETITIVE MARKETS have many small firms and there’s
nothing to prevent entry into the market of new firms; but these firms sell a
differentiated product.
C. OLIGOPOLISTIC MARKETS have few interdependent firms and there are barriers
preventing new firms from entering. The product may be either homogeneous or
differentiated.
D. In a MONOPOLY market there is one firm dominating the market and there are
barriers preventing new firms from entering.
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ENTRY BARRIERS are any kind of obstacles that deter new companies from entering a given
market. Firms try to erect barriers to limit competition and to be able to keep any
supernormal profits. Common entry barriers include:
a. a limited number of government licences (ex. television station)
b. a patent protection regulations (ex. pharmaceuticals)
c. strong brand identity and customer loyalty, heavy advertising
d. technology challenges and start-up costs.
Perfectly competitive markets
Firms in perfect competition have no market power. This means there are so many firms
operating, and each is so small compared to the market, that any one of them cannot affect
the price that market forces determine - each of these firms is a price-taker.
If the typical firm starts to make supernormal profits, there is an incentive for others to
enter the market. They can enter it because, in perfect competition, there are no entry
barriers. On the other hand, if the typical firm was making an economic loss, then it would
exit the market.
In the short run, the typical firm can make supernormal profits, normal economic profits, or
even economic losses. In the long run, though, the typical firm will necessarily make zero
economic profits; that is, only normal profits. Entry and exit will ensure this outcome.
A NATURAL MONOPOLY is a monopoly in an industry in which high infrastructural costs and
other barriers to entry relative to the size of the market give the largest supplier in an
industry, often the first supplier in a market, an overwhelming advantage over potential
competitors.
ECONOMIES OF SCALE are cost advantages companies experience when production
becomes efficient, as costs can be spread over aa larger amount of goods.
The CONCENTRATION RATIO is used to quantify market concentration and are based on
companies' market shares in a given industry. It is the proportion of total market sales
accounted by the n largest firms, where n is usually, but not necessarily, the four largest
firms in terms of sales.
Interdependence exists if the outcome of any action of one firm depends on the reaction of
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rival firms. Interdependence in oligopolistic markets implies greater uncertainty and the risk
of a price war when firms compete by successively cutting price.
COLLUSION exists when firms agree to fix prices and engage in other anti-competitive
behaviour. This is generally illegal as it undermines the most basic benefit of free markets,
that of competition.
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