IB Economics 2.11.10 Risks in Markets Dominated by One or a Few Very Large Firms Notes

Market Power: Why a Dominant Firm Charges More and Produces Less

1. When one firm or a few large firms dominate a market, they gain market power, the ability to set price rather than accept the price the market sets.
2. A dominant firm faces the whole downward-sloping industry demand curve, so it can pick the point on that curve it prefers.
3. It sets output where marginal revenue equals marginal cost, then charges the highest price buyers will pay for that output.
   1. That output sits below the competitive level and the price above it, because no rivalry forces price down to marginal cost.
4. Because industry demand is relatively inelastic, holding output back costs the firm few sales while lifting the price it earns on the units it does sell.
5. High barriers to entry keep new rivals out, so the extra output those rivals would have supplied never appears.

Allocative and Productive Inefficiency: A Welfare Loss

1. A market is allocatively efficient when the last unit produced is worth exactly what it costs to make, which happens where price equals marginal cost.
2. A dominant firm produces less than that, so its price sits above marginal cost.
3. Every unit between the firm's output and the competitive output is worth more to buyers than it costs, yet none of those units is made.
   1. The value society loses on those missing units is the welfare loss, the shaded triangle between the demand curve and the marginal cost curve.
4. This is the core reason concentrated market power is treated as a market failure.
   1. Mylan raised the US list price of the EpiPen from around $100 to over $600 for a twin-pack, and every buyer who valued it above its low production cost but below $600 is a unit of lost welfare.
5. The firm is also productively inefficient, because producing where $MR = MC$ leaves output below the lowest point of average total cost.
   1. Barriers to entry keep it there in the long run too, unlike perfect competition, where entry drives firms to minimum $ATC$.

Even Mild Market Power Misses Productive Efficiency

1. Productive inefficiency is not unique to a dominant firm, because it follows from facing a downward-sloping demand curve, which any firm with market power does.
2. A monopolistically competitive firm has only a sliver of power from differentiating its product, yet the same failure appears in both the short run and the long run.
3. In the short run it produces where $MR = MC$, at an average cost above minimum $ATC$.
4. Free entry then competes its profit away, but the long-run tangency of demand to $ATC$ still sits to the left of minimum $ATC$, so the inefficiency never goes away.

Complacency: Weak Competition Raises Costs and Narrows Choice

1. Competition forces firms to cut waste, because a firm that lets its average costs drift upward is undercut by leaner rivals and loses customers.
2. A dominant firm shielded by high barriers loses that discipline, so it can carry slack and tolerate waste while still surviving.
   1. This gap between actual average cost and the lowest cost it could reach is X-inefficiency.
3. The same lack of pressure dulls the incentive to innovate, so buyers get fewer new products.
4. Choice narrows further, because with only one or a few producers there are fewer firms to switch to and fewer niche products for smaller groups of buyers.

Abuse of Market Power: Barriers, Predatory Pricing, and Collusion

1. Market power also gives a dominant firm tools to protect its position, and three of them do direct harm.
   1. Barriers to entry: it uses its scale and control over supply to make it hard for new firms to break in.
   2. Predatory pricing: it cuts price below cost long enough to drive a smaller rival out, then raises price once the threat is gone.
   3. Collusion: where a few firms share a market, they agree to hold prices high instead of competing.
2. Collusion is hard to hold together, because each firm can earn more by quietly cutting its price to win customers while the others keep theirs high.
   1. That temptation to defect is why cartels often break down.
   2. OPEC shows both sides, agreeing oil output quotas to keep prices high, yet members often pump above quota to grab extra revenue, which repeatedly strains the cartel.
3. Still, concentration does not always harm buyers.
   1. A large firm can use its scale to fund research a small firm could not afford, which can widen choice over time.
   2. A few firms may also compete hard on price to win market share, which holds prices down.