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Chapter 5 Notes
I. GENERAL COMMENTS AND DEFINITIONS
A. Market Power
1. Firms have market power when the following conditions exist.
a. Firms can influence price in attempts to increase profits.
b. The existence of profits does not attract new firms into the industry.
2. The following conditions are required for market power.
a. A few firms control the product.
b. There are limitations on the entry of new firms.
B. Monopoly
1. A monopoly is a single seller of a product with no close substitutes.
C. Oligopoly
1. An oligopoly is a market with a few producers or sellers of a good.
D. Cartel
1. A cartel is an organized group of firms who manage output and pricing as if they were a
monopoly.
II. MONOPOLY ANALYSIS
A. Demand
1. Because the monopolist is a single seller, it faces the market demand curve for the product
produced.
a. This demand curve is negatively sloped and shows that the monopolist can sell more
output only by lowering the price of the product.
1. This means that the output the monopolist chooses to sell affects price.
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B. Marginal Revenue
1. Marginal revenue is the change in total revenue associated with selling one more unit of
output.
a. It is the private benefit to the monopolist of selling one more unit.
2. For a monopolist, marginal revenue is less than price.
a. Because the monopolist must lower the price on all units in order to sell additional units,
marginal revenue is less than price.
b. Because marginal revenue is less than price, the marginal revenue curve will lie below
the demand curve.
1. Because demand represents marginal social benefit and marginal revenue represents
marginal private benefit, marginal social benefit is greater than industry marginal
private benefit in monopoly.
C. The Marginal Principle
1. In choosing the output to produce, the monopolist follows the marginal principle.
a. This principle states the profit maximizing output is that output where marginal revenue
equals marginal cost.
1. If marginal revenue is greater than marginal cost, the monopolist should
increase output.
2. If marginal revenue is less than marginal cost, the monopolist should decrease
output.
D. Monopoly and Competition Compared
1. Unlike a competitive industry, a monopoly does not produce the efficient output.
Monopolists charge a higher price and produce less output than a competitive industry.
a. Efficient output occurs where marginal social cost and marginal social benefit are equal.
b. Inefficiency occurs because of the divergence between marginal social benefit and
marginal social cost.
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1. At the output produced by the monopolist, marginal social benefit exceeds marginal
social cost.
a. The value to consumers of an additional unit exceeds the value of the units of
other goods given up to produce the additional unit - the opportunity cost.
III. MARKET POWER AND ECONOMIC EFFICIENCY
A. The Trend in Market Power
1. Some studies indicate that the U.S. economy is becoming more competitive.
a. Increased competition from imports in the manufacturing sector has decreased market
power.
b. Government deregulation of the economy has decreased market power.
c. Federal government policies making mergers and price fixing more difficult have
decreased market power.
d. The information revolution has increased competition in many industries, resulting in a
decrease in market power.
B. Barriers to Entry
1. There are four major sources of market power in the United States.
a. Technical conditions can create entry barriers.
1. Technical conditions might be such that a technically efficient firm will supply all of
a good that consumers wish to purchase at the going price.
a. Monopolies created by these technical conditions are sometimes referred to as
natural monopolies.
b. Access to the supply of a product or an essential input for a product can create a barrier to
entry.
c. Existing firms may develop and maintain market power through product differentiation.
d. Monopolies may be created by government regulations.
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IV. OPEC: A FEW SELLERS ACTING LIKE A MONOPOLY
A. Cartel Formation
1. Three variables are important in determining the success of forming and maintaining a cartel.
a. The cartel must reach an agreement that all producers will abide by.
1. This agreement stipulates the total output to be produced by the cartel and the
division of production among the members.
b. The cartel must continue to cooperate and come to new agreements as conditions change.
c. The agreement must be enforced.
1. Because it is very profitable for cartel members to cheat on the original agreement,
there must be some method of enforcement.
B. The Determinants of Cartel Success
1. The fewer the number of firms and the more similar they are, the easier it is to form and
operate a cartel.
a. As the number of firms increases, it becomes more difficult to include all the firms in the
industry.
b. As the number of firms increases, it becomes more difficult to detect cheating on the
agreement.
2. If firms are not similar, it becomes more difficult to determine the division of output and
profits.
C. Problems of the OPEC Cartel
1. There are three factors accounting for the serious problems encountered by the OPEC cartel.
a. There are many members, as well as several nonmember petroleum producers.
1. The existence of large profits attracted entry to the industry and drove the price of
petroleum down.
b. The members are dissimilar in that they have different and conflicting goals.
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1. Countries with small reserves relative to population want higher prices now, while
countries with relatively large reserves are more concerned with long-run profits.
c. The demand for petroleum is more elastic in the long run.
1. Over time consumers have made adjustments to the higher OPEC price.
V. MARKET POWER AND ECONOMIC GROWTH
A. Basis of Economic Growth
1. Knowledge and the creation of new knowledge are the basis for much economic growth and
for the growth of many firms.
2. Knowledge-based firms have several feature that lead to a monopoly or near-monopoly of
their products.
a. The development of the product involves huge start-up costs.
b. There are large up-front costs involved in producing the product that has been developed.
3. Government grants monopolies of new products through copyrights and patents so that firms
can cover the start-up and up-front costs of developing a product.
a. Microsoft’s first disk of Windows probably cost $50 million. Subsequent disks cost $3.
VI. GOVERNMENT AND MARKET POWER
A. Antitrust Laws
1. Antitrust laws prohibit price fixing and other types of explicit cartel or monopoly behavior.
2. Antitrust laws prohibit mergers in certain instances.
a. A merger is a combination of two or more firms into one firm.
3. Through the use of antitrust laws, government discourages market power.
4. Antitrust laws should not necessarily be used to restructure all firms with market power.
a. If the industry is a natural monopoly, monopoly profit may provide incentives for
innovations that, over time, would reduce or eliminate market power.
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b. The existence of monopoly profits provides an incentive for economic rent seeking.
c. The existence of profits encourages new firms to come into the industry causing prices to
be lowered.