The marginal cost curve for plant 1 is higher than the marginal cost curve for plant 2, reflecting the older, less efficient plant. Rather than shutting the less efficient plant down, the monopolist should produce some output in each plant, and set the MC of each plant equal to MR, as shown in the graph. The outcome of the multiplant monopolist yields useful conclusions for any firm: continue using any input, plant, or resource until marginal costs equal marginal revenues. Less efficient resources can be usefully employed, even if more efficient resources are available.
The next section will explore the determinants and measurement of monopoly power, also called market power. In this section, the determinants and measurement of monopoly power are examined. Economists use the Lerner Index to measure monopoly power, also called market power.
The index is the percent markup of price over marginal cost. A monopolist will have a Lerner Index greater than zero, and the index will be determined by the amount of market power that the firm has. A larger Lerner Index indicates more market power. In Section 3. Substitution of this pricing rule into the definition of the Lerner Index provides the relationship between the percent markup and the price elasticity of demand. An example of a Lerner Index might be Big Macs. There are substitutes available for Big Macs, so if the price increases, consumers can buy a competing brand such as Whoppers.
In the case of a good with close substitutes, the price elasticity of demand is larger more elastic , causing the percent markup to be smaller: the Lerner Index is relatively small.
A monopoly is defined as a single seller in an industry with no close substitutes. Therefore, a monopoly that produces a good with no close substitutes would have a higher Lerner Index.
A second pricing rule can be derived from equation 3. This is a useful equation, as it relates price to marginal cost. The price is two times the production costs in this case. To summarize:. A monopoly example is useful to review monopoly and the Lerner Index.
Profit-maximization yields the optimal monopoly price and quantity. To calculate the value of the Lerner Index, price and marginal cost are needed equation 3. This is the first derivative of the inverse demand function. The same result was achieved using both methods, so the Lerner Index for this monopoly is equal to 0.
The competitive price and quantity are P c and Q c. The welfare analysis of a monopoly relative to competition is straightforward. Consumers are losers, and the benefits of monopoly depend on the magnitudes of areas A and C. Since a monopolist faces an inelastic supply curve no close substitutes , area A is likely to be larger than area C, making the net benefits of monopoly positive. The monopoly example from the previous section 3.
The competitive solution is found where the demand curve intersects the marginal cost curve. The welfare analysis of monopoly has been used by the government to justify breaking up monopolies into smaller, competing firms. In food and agriculture, many individuals and groups are opposed to large agribusiness firms.
One concern is that these large firms have monopoly power, which results in a transfer of welfare from consumers to producers, and deadweight loss to society. It will be shown below that outlawing or banning monopolies would have both benefits and costs. There is some economic justification for the existence of large firms due to economies of scale and natural monopoly, as will be explored below. Next, the sources of monopoly power will be listed and explained.
The price elasticity of demand depends on how large the firm is relative to the market. However, if all firms in the market increase the price of the good, consumers have no close substitutes, so must pay the higher price Figure 3. The second determinant of market power is the number of firms in an industry. This is related to Figure 3. If a firm is the only seller in an industry, then the firm is the same as the market, and the price elasticity of demand is the same for both the firm and the market.
The more firms there are in a market, the more substitutes a consumer has available, making the price elasticity of demand more elastic as the number of firms increases. To summarize, the more firms there are in an industry, the less market power the firm has. The number of firms in an industry is determined by the ease or difficulty of entry. Each of these barriers to entry increases the difficulty of entering a market when positive economic profits exist.
Economies to scale and natural monopoly are defined and described in the next s ection. Some industries are characterized by one or two dominant firms. These large firms often exert market power. The third source of market power is interaction among firms. On the other hand, if firms cooperate and act together, the firms can have more market power.
These strategic interactions between firms form the heart of the discussion in Chapter 5, and the foundation for game theory, explored in Chapters 6 and 7. A natural monopoly is a firm that has a high level of costs that do not vary with output. The fixed costs are those costs that do not vary with the level of output.
When fixed costs are high, then average total costs are declining, as seen in Figure 3. This means that the demand curve intersects the AC curve while it is declining.
The demand curve has a portion above the AC curve, so positive profits are possible. Suppose that the monopoly was making positive economic profits, and attracted a competitor into the industry. The second firm would cause the demand facing each of the two firms to be cut in half.
This possibility can be seen in Figure 3. This is because for a linear demand curve, the MR curve has the same y-intercept and twice the slope. Notice the position of the MR curve for a natural monopoly: it lies everywhere below the AC curve. Therefore, positive profits are not possible for two firms serving this market. The demand is not large enough to cover the fixed costs.
The fixed costs are typically large investments that must be made before the good can be sold. For example, an electricity company must build both a huge generating plant and a distribution network that connects all residences and businesses to the power grid. These enormous costs do not vary with the level of output: they must be paid whether the firm sells zero kilowatt hours or one million kilowatt hours.
This feature is true for many large businesses, and provides economic justification for large firms: the per-unit costs of production are smaller, providing lower costs to consumers. There is a tradeoff for consumers who purchase goods from large firms: the cost is lower due to economies of scale, but the firm may have market power, which can result in higher prices. This tradeoff makes the economic analysis of large firms both fascinating and important to society.
Current examples include the giant technology companies Microsoft, Apple, Google, and Amazon. Natural monopolies have important implications for how large businesses provide goods to consumers, as is explicitly shown in Figure 3.
The industry in Figure 3. The price is high: consumers lose welfare and society is faced with deadweight losses. This is a desirable outcome for the consumers. However, there is a major problem with this outcome: price is below average costs, and any business firm that charged the competitive price P C would be forced out of business.
In this case, the firm does not have enough revenue to cover the fixed costs. A single monopoly firm could earn enough revenue to stay in business, but consumers would pay a high monopoly price P M. If competition occurred, the consumers would pay the cost of production P C , but the firms would not cover their costs.
One solution to a natural monopoly is government regulation. This analysis explains why the government regulates many public utilities for electricity, natural gas, water, sewer, and garbage collection.
The next section will investigate monopsony, or a single buyer with market power. Monopsony power is market power of buyers. The actual or potential exercise of market power is used to determine whether or not substantial lessening of competition exists or is likely to occur. An approach adopted in the administration of merger policy in the United States and Canada seeks to predict whether, post-merger, the parties can institute a non-transitory price increase above a certain threshold level say 5 or 10 per cent which will vary depending on the case without attracting entry of new firms or production of substitute products.
Their ability to maintain or exceed this price threshold is assessed by detailed examination of quantitative and qualitative market structure and firm behaviour factors.
Source Publication:. Khemani and D. Statistical Theme: Financial statistics. Created on Thursday, January 3, Select basic ads.
Create a personalised ads profile. Select personalised ads. Apply market research to generate audience insights. Measure content performance. Develop and improve products. List of Partners vendors. Market power refers to a company's relative ability to manipulate the price of an item in the marketplace by manipulating the level of supply, demand or both. A company with substantial market power has the ability to manipulate the market price and thereby control its profit margin, and possibly the ability to increase obstacles to potential new entrants into the market.
Firms that have market power are often described as "price makers" because they can establish or adjust the marketplace price of an item without relinquishing market share. Market power is also known as pricing power. In a market where many producers exist that compete with each other to sell a similar product, such as wheat or oil, producers have very limited market power. Market power can be understood as the level of influence that a company has on determining market price, either for a specific product or generally within its industry.
An example of market power is Apple Inc. Although Apple cannot completely control the market, its iPhone product has a substantial amount of market share and customer loyalty, so it has the ability to affect overall pricing in the smartphone market.
The ideal marketplace condition is what is referred to as a state of perfect competition, in which there are numerous companies producing competing products, and no company has any significant level of market power. In markets with perfect or near-perfect competition, producers have little pricing power and so must be price-takers. Of course, that is merely a theoretical ideal that rarely exists in actual practice. Many countries have antitrust laws or similar legislation designed to limit the market power of any one company.
Market power is often a consideration in government approval of mergers. A merger is unlikely to be approved if it is believed that the resulting company would constitute a monopoly or would become a company with inordinate market power. The scarcity of a resource or raw material can play a significant role in pricing power, even more so than the presence of rival providers of a product.
For example, various threats , such as disasters that put the oil supply at risk, lead to higher prices from petroleum companies, despite the fact that rival providers exist and compete in the market.
The narrow availability of oil, combined with the widespread reliance on the resource across multiple industries means that oil companies retain significant pricing power over this commodity.
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