IB Economics 2.11.5 Degrees of Market Power Notes

Market Power Comes in Degrees

1. Market power is a firm's ability to influence its own price rather than accept a price set by the market.
2. It is not all-or-nothing, but comes in degrees, from none at all to complete control.
3. At one end sits perfect competition, where many firms sell an identical product and each is a price taker with zero power.
4. At the other sits monopoly, a single firm with a unique product and the most power, a price maker.
5. Monopolistic competition and oligopoly fall in between, with mild and then substantial power.
6. The further a market sits from perfect competition, the more a firm can hold price above marginal cost.

More Power Means Less Allocative Efficiency

1. Line the four structures up and one pattern stands out: more market power always means less allocative efficiency.
2. A price taker produces where price equals marginal cost, $P = MC$, so the last unit is worth exactly what it costs and no beneficial trade is missed.
3. A firm with power holds price above marginal cost, so units that consumers value above their cost go unproduced.
   1. That gap between price and marginal cost widens as power grows, from none in perfect competition to the largest under monopoly.

Every Firm Maximises Where MC = MR

1. Whatever its power, every firm maximises profit by the same rule: produce where marginal cost equals marginal revenue, $MC = MR$.
2. In perfect competition the firm is a price taker, so marginal revenue equals the market price and the rule becomes $MC = P$.
3. Whether that output earns a profit or a loss depends on how price compares with average total cost at that quantity.
   1. If price is above $ATC$, the firm earns abnormal profit, shown by the shaded rectangle on the left.
   2. If price is below $ATC$, it makes a loss, shown by the shaded rectangle on the right.
4. Profit or loss per unit is the gap between price and $ATC$, and the total is that gap times quantity $Q$.

Imperfect Firms Keep Price Above MC

1. An imperfect firm follows the same $MC = MR$ rule, with one change.
2. Because it is a price maker facing a downward-sloping demand curve, its marginal revenue lies below price.
3. It sets output where $MR = MC$, then reads its price up to the demand curve, leaving price above marginal cost.
   1. That gap between price and marginal cost is its market power.
4. Just like a price taker, it earns abnormal profit when price is above $ATC$, or a loss when price is below it.
   1. The shaded rectangle again measures profit or loss as the price to $ATC$ gap times quantity.

In the Long Run, Competition Erodes Profit

1. In perfect competition, short-run profit or loss does not last, because entry and exit are free.
2. Abnormal profit attracts new firms, whose extra output shifts market supply right and drives the price down.
   1. In the diagram, market supply moves from $S_{M1}$ to $S_{M2}$ and price falls from $P_1$ to $P_2$.
3. A loss does the reverse: firms leave, supply shifts left, and the price rises back up.
4. Entry and exit stop only when price reaches the lowest point of average total cost, where firms earn just normal profit.
   1. At that point $P = $ minimum $ATC$, so the firm is both allocatively and productively efficient.

Perfect Competition: Strong in Theory, Limited in Practice

Perfect competition is prized as an efficiency benchmark, yet its assumptions rarely hold in real markets.

1. Strengths
   1. Allocative and productive efficiency: in the long run price equals marginal cost at the minimum of $ATC$.
   2. Low prices: free entry competes any abnormal profit away to the lowest sustainable level.
   3. Responsive to demand: free entry and exit keep moving resources to the goods consumers want.
2. Limits
   1. Unrealistic assumptions: perfect information and identical products are rare in practice.
   2. No economies of scale: small price takers cannot reach the cost savings larger firms enjoy.
   3. Little innovation: earning only normal profit leaves no surplus to fund research or development.