IB Economics Topic 2.11.5 Degrees of Market Power Revision Notes (HL)

IB Economics Topic 2.11.5 Degrees of Market Power Revision Notes (HL) | RevisionDojo

Written by official IB examiners

Meaning of market power

Definition

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:
1. Number of firms in the market.
2. Product differentiation: how similar (or different) are the goods or services offered.
3. Barriers of entry: how hard is it to enter the market as a new firm.
4. Degree of market power.
Looking at these characteristics, there are four main types of market structures:
1. Perfect competition → no market power.
2. Monopolistic competition → some market power.
3. Oligopoly → a lot of market power.
4. Monopoly → complete market power.

Note

In this section, we will discuss the characteristics of perfect competition.

Perfect competition: no market power, firm as price taker

Definition

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).

Tip

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:
1. Quantity demanded.
2. Quantity produced (sold).
This is because all those measures are expressed in terms of quantity.
The y axis represents:
1. Price.
2. Revenue.
3. 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.

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Definition

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Duis aute irure dolor in reprehenderit

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Note

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Excepteur sint occaecat cupidatat non proident

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Tip

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Lorem ipsum dolor sit amet, consectetur adipiscing elit.
Sed do eiusmod tempor incididunt ut labore et dolore magna aliqua.
Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris.
Duis aute irure dolor in reprehenderit in voluptate velit esse cillum.

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Meaning of market power

Definition

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:
1. Number of firms in the market.
2. Product differentiation: how similar (or different) are the goods or services offered.
3. Barriers of entry: how hard is it to enter the market as a new firm.
4. Degree of market power.
Looking at these characteristics, there are four main types of market structures:
1. Perfect competition → no market power.
2. Monopolistic competition → some market power.
3. Oligopoly → a lot of market power.
4. Monopoly → complete market power.

Note

In this section, we will discuss the characteristics of perfect competition.

Perfect competition: no market power, firm as price taker

Definition

Perfect competition

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).

Tip

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:
1. Quantity demanded.
2. Quantity produced (sold).
This is because all those measures are expressed in terms of quantity.
The y axis represents:
1. Price.
2. Revenue.
3. 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.

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.

Definition

Paywall

(on a website) an arrangement whereby access is restricted to users who have paid to subscribe to the site.

anim nostrud sit dolore minim proident quis fugiat velit et eiusmod nulla quis nulla mollit dolor sunt culpa aliqua

Duis aute irure dolor in reprehenderit

Note

Lorem ipsum dolor sit amet, consectetur adipiscing elit, sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam quis nostrud exercitation.

Excepteur sint occaecat cupidatat non proident

Tip

Lorem ipsum dolor sit amet, consectetur adipiscing elit.
Sed do eiusmod tempor incididunt ut labore et dolore magna aliqua.
Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris.
Duis aute irure dolor in reprehenderit in voluptate velit esse cillum.

1. Introduction to Economics2 subtopics

2. Microeconomics12 subtopics

3. Macroeconomics7 subtopics

4. The Global Economy10 subtopics

IB Economics 2.11.5 Degrees of Market Power Notes

1. Introduction to Economics2 subtopics

2. Microeconomics12 subtopics

3. Macroeconomics7 subtopics

4. The Global Economy10 subtopics

Meaning of market power

Perfect competition: no market power, firm as price taker

Profit maximisation in the short run

Interpreting Figure 1

The axis

The demand curve

Abnormal profit

Normal profit

Losses

anim nostrud sit dolore minim proident quis fugiat velit et eiusmod nulla quis nulla mollit dolor sunt culpa aliqua

Duis aute irure dolor in reprehenderit

Excepteur sint occaecat cupidatat non proident

Unlock the rest of this chapter with a free account

Meaning of market power

Perfect competition: no market power, firm as price taker

Profit maximisation in the short run

Interpreting Figure 1

The axis

The demand curve

Abnormal profit

Normal profit

Losses

anim nostrud sit dolore minim proident quis fugiat velit et eiusmod nulla quis nulla mollit dolor sunt culpa aliqua

Duis aute irure dolor in reprehenderit

Excepteur sint occaecat cupidatat non proident

Unlock the rest of this chapter with a free account