Meaning of market power
Market power
The degree to which a firm in a market is able to control its output price.
- Market power is the degree to which firms are able to control the price at which they sell their goods and services on the market.
- Different market structures have different degrees of market power.
- Market structures can be categorised by looking at each of the following characteristics:
- Number of firms in the market.
- Product differentiation: how similar (or different) are the goods or services offered.
- Barriers of entry: how hard is it to enter the market as a new firm.
- Degree of market power.
- Looking at these characteristics, there are four main types of market structures:
- Perfect competition → no market power.
- Monopolistic competition → some market power.
- Oligopoly → a lot of market power.
- Monopoly → complete market power.
In this section, we will discuss the characteristics of perfect competition.
Perfect competition: no market power, firm as price taker
Perfect competition
A market structure with a large number of small firms that have no control over output prices. All firms sell an undifferentiated product and there are no barriers to entry.
Firms in a perfect competition market:
- Are small-sized and there are many firms in the market.
- Sell an undifferentiated product.
- Can easily enter the market without barriers to entry.
- Sell their products at the price demanded by the market.
As a market structure, perfect competition markets have the following characteristics:
- Maximise profits in the long-run.
- Achieve allocative efficiency.
Profit maximisation in the short run
- In the previous subtopic we saw that profit maximisation occurs when MB = MC.
- If we combine all the marginal and average costs and revenues, as well as supply and demand into one single diagram (Figure 1), we can see the different types of profits (normal, abnormal, and losses) firms can make when producing at a profit maximisation level of output ($Q_{max}$).
- In the short-run, firms in perfect competition can be making any kinds of profit (abnormal, normal, losses).
Interpreting Figure 1
Figure 1 illustrates three firms in perfect competition markets in the short-run:
- One making normal profits.
- One making abnormal profits.
- One making losses.
The axis
- The x axis represents:
- Quantity demanded.
- Quantity produced (sold).
- This is because all those measures are expressed in terms of quantity.
- The y axis represents:
- Price.
- Revenue.
- Cost.
- This is because all those measures are expressed in terms of currency.
The demand curve
The demand curve is horizontal because in perfect competition markets firms take the price determined by the market.
- Imagine a local market where there are 20 fruit stores that sell oranges of the exact same quality (undifferentiated).
- The supply and demand forces of the market agree on the equilibrium price, and the firms in the perfect competition market must sell at this price (Figure 2).
- If a firm sells oranges at a higher price than the rest, no one will buy them (assuming rational consumer behaviour).
- If a firms lowers its output prices, they lose profits.
Therefore, the demand a firm faces in a perfect competition market is perfectly elastic, and equals its output price, marginal revenue, and average revenue (to understand why $D=P=MR=AR$, see Table 4 in 2.11.4).
Abnormal profit
- Firms always produce at $Q_{max}$, where profit maximisation occurs. This point is when $MR=MC$, so when the MR and MC curves intersect.
- However, at this $Q_{max}$, $AR > AC_1$, and so the firm is making abnormal profit.
- The average profit per unit equals the difference, at $Q_{max}$ between the average revenue (equal to $P_{e}$) and the average cost ($AC_1$).
- The total profit equal the average profit ($P_{e}-AC_1$) times the units produced ($Q_{max}$):
$$(P_{e}-AC_1) \times Q_{max}$$
This is visualised by the red box.
Normal profit
- Firms always produce at $Q_{max}$, where profit maximisation occurs. This point is when $MR=MC$, so when the MR and MC curves intersect.
- At this $Q_{max}$, $AR = AC_2$, and so the firm is making normal profit.
- The average profit per unit equals the difference between the average revenue (equal to $P_{e}$) and the average cost ($AC_2$).
- Since $P_{e}=AC_2$ in this case, the firm is making normal (zero) profit.
Losses
- Firms always produce at $Q_{max}$, where profit maximisation occurs. This point is when $MR=MC$, so when the MR and MC curves intersect.
- However, at this $Q_{max}$, $AR < AC_3$, and so the firm is making losses.
- The average profit per unit equals the difference between the average revenue (equal to $P_{e}$) and the average cost (AC_3).
- The total profit equal the average profit ($P_{e}-AC_3$) times the units produced ($Q_{max}$):
$$(P_{e}-AC_3) \times Q_{max}$$
However, since $AC>P_{max}$, the total profit is negative, the firm is making losses. These total losses are visualised by the red box.
Profit maximisation in the long run
NoteIn the long run, all firms in a perfect competition market make normal profits.
- In the long run, all factors are variable → firms can enter, exit, or change size, meaning market conditions adjust over time.
- If the firms in perfect competition market are making abnormal profits, they will attract new firms to the market → increased market supply lowers prices, reducing AR until only normal profit (AR = AC) remains.
- Contrarily, if firms face losses for a long time, some will exit the market → supply decreases, raising prices and AR until remaining firms earn normal profit.
Allocative efficiency of perfect competition
Allocative Efficiency
Allocative efficiency refers to the situation where the market produces the socially desirable quantity of output.
- As we discussed in previous sections, allocative efficiency is reached, when:
- Marginal Benefit (MB) = Marginal Cost (MC).
- This occurs when P = MC.
- In the long-run, in perfect competition markets, all firms produce at a point where P = MC.
- Therefore, perfect competition leads to allocative efficiency.
Note however that this statement is true only when there are no externalities in the market.
Evaluating perfect competition
Advantages of perfect competition
- Allocative efficiency in the long run:
