Study Notes: Market Failure—Market Power (HL Only)
Hello HL Economists! This is where we dive deeper into microeconomics. We've learned that competitive markets are fantastic at allocating resources efficiently. But what happens when competition disappears? That’s the core of this chapter: Market Power. This concept explains why things like prescription drugs or specific software can be so expensive, and how powerful firms distort the perfect market balance. Don't worry if the diagrams seem complex; we will break them down step-by-step!
Remember: Market failure occurs when the market, left to its own devices, fails to achieve allocative efficiency (\(P = MC\)). Market power is one of the most common causes of this failure.
I. Defining and Understanding Market Power
What is Market Power?
Market power refers to the ability of a firm or group of firms to influence the price of a good or service in the market. In simple terms, they can raise prices above the competitive level without losing all their customers.
- Perfect Competition (PC): Firms have zero market power. They are price takers. If they raise the price, they lose all sales.
- Monopoly/Oligopoly: Firms have significant market power. They are price makers (or price searchers). They face a downward-sloping demand curve.
How is Market Power Created?
Market power usually arises because of high barriers to entry (factors that prevent new firms from entering the industry). These include:
- Legal Barriers: Patents, copyrights, government licenses (e.g., utility providers).
- Economies of Scale (Natural Monopoly): When one firm can produce the entire output of the market at a lower average cost than two or more firms. (Think about water or electricity networks.)
- Control of Essential Resources: Owning the only source of a key input.
- Brand Loyalty/Advertising: Creating strong consumer preference that acts as a barrier.
Quick Takeaway: Market power is the ability to choose your price, rather than having the market dictate it. The more control a firm has, the closer it moves toward being a monopoly.
II. The Monopoly Model: The Extreme Case
To analyze the negative consequences of market power, we usually focus on the purest form: the Monopoly (a single seller).
Profit Maximization for a Monopolist
Unlike a firm in perfect competition where \(P = MR\), a monopolist must lower the price of all units sold if they want to sell an extra unit. This causes their Marginal Revenue (MR) curve to fall below the Demand (D) curve (which is also the Average Revenue, AR, curve).
The Golden Rule for Profit: Like all firms, a monopolist maximizes profits by producing where Marginal Revenue equals Marginal Cost.
\[MR = MC\]
Step-by-Step Diagram Analysis
When drawing the monopoly model, follow these steps:
- Draw the downward-sloping Demand (AR) curve and a steeper, lower Marginal Revenue (MR) curve.
- Draw the Marginal Cost (MC) curve and the U-shaped Average Total Cost (ATC) curve.
- Step 1 (Find Quantity): Identify the intersection point of MR and MC. Drop a vertical line down to the x-axis to find the profit-maximizing output, \(Q_M\).
- Step 2 (Find Price): Move vertically up from \(Q_M\) until you hit the Demand (AR) curve. Move horizontally to the y-axis to find the monopolist’s price, \(P_M\). (This shows the price consumers are willing to pay for that quantity).
- Step 3 (Find Profit): Move vertically up from \(Q_M\) until you hit the ATC curve. This shows the average cost, \(C_M\). The shaded rectangle of \((P_M - C_M) \times Q_M\) is the economic (supernormal) profit.
Did You Know? A monopolist doesn't technically have a "supply curve." Because they are price makers, their output decision depends on both MC and the demand curve simultaneously, not just the MC curve alone.
III. Market Power as Market Failure (Inefficiency)
The core problem with market power, from society's point of view, is that it leads to a lower quantity being sold at a higher price compared to a perfectly competitive market. This creates three types of inefficiency:
1. Allocative Inefficiency (\(P > MC\))
Definition: Allocative efficiency occurs when resources are allocated to produce the combination of goods and services most wanted by society. This happens when Price equals Marginal Cost (\(P = MC\)).
The monopolist sets its price (\(P_M\)) far above its marginal cost (MC). Why is this bad?
- The Issue: The price paid by consumers (\(P_M\)) measures the benefit society gets from the last unit consumed. The MC measures the cost to society of producing that last unit.
- Since \(P_M > MC\), it means consumers value additional units of the product more than the cost to society to produce them. The monopolist, however, stops producing, resulting in underproduction.
Analogy: Imagine a line of people willing to pay $10 for a coffee that only costs $3 to make. The allocatively efficient outcome is for the coffee shop to keep making coffee until the price the next person is willing to pay hits $3. The monopolist stops selling at $15 because they maximize their own profit, not society's welfare.
2. Productive Inefficiency (Not at Minimum ATC)
Definition: Productive efficiency occurs when production takes place at the lowest possible cost, specifically at the minimum point of the Average Total Cost (ATC) curve.
- Monopolists typically produce on the downward-sloping portion of their ATC curve, not at the minimum point. This means they are not utilizing their resources fully or efficiently.
- In the long run, supernormal profits allow the monopolist to become complacent and lack the incentive to minimize costs (sometimes called X-inefficiency).
3. Welfare Loss (Deadweight Loss - DWL)
The combined allocative inefficiency results in a loss of economic welfare known as deadweight loss (DWL).
Step-by-Step Calculation of DWL (Diagrammatic)
- Competitive Equilibrium (\(Q_{PC}\), \(P_{PC}\)): This is the socially efficient point where Demand (D) intersects Marginal Cost (MC), as \(P = MC\). This gives maximum total surplus.
- Monopoly Equilibrium (\(Q_M\), \(P_M\)): This is the profit-maximizing point derived from \(MR = MC\).
- Consumer Surplus (CS) Loss: When the price rises from \(P_{PC}\) to \(P_M\), the CS shrinks significantly.
- DWL Identified: The DWL is the triangular area that points toward the efficient competitive point (where D=MC). It represents the total surplus (both consumer and producer) that is lost to society because the monopolist restricted output from \(Q_M\) to \(Q_{PC}\).
Memory Trick: Think of DWL as the Dead Weight of the market failure. It's the mutually beneficial transactions that never happen because of the high price. It’s the cost of monopoly power to society.
Quick Review Box: The Monopoly Problem
Perfect Competition: \(P_{PC} = MC\) (Allocatively Efficient) and operates at minimum ATC (Productively Efficient).
Monopoly: \(P_M > MC\) (Allocatively Inefficient) and does not operate at minimum ATC (Productively Inefficient).
IV. Government Responses to Market Power
Because market power leads to inefficiency, governments often intervene to try and replicate the competitive outcome or minimize the damage.
1. Regulation and Competition Law (Antitrust)
Purpose: To prevent firms from gaining or abusing market power.
- Breaking up Monopolies: If a dominant firm is proven to engage in anti-competitive behavior (e.g., predatory pricing), governments may force it to divide into smaller, competing firms (e.g., the break up of Standard Oil in the US a century ago).
- Preventing Mergers: Authorities (like the EU Competition Commission or the US Justice Department) review mergers and acquisitions. If a merger results in too much market concentration, they can block it. (Example: Blocking large airline mergers if it severely limits consumer choice.)
- Controlling Anti-Competitive Behavior: Imposing fines for price-fixing (collusion) or establishing illegal monopolies.
2. Regulation of Natural Monopolies
In cases where competition is economically inefficient (like utilities requiring huge infrastructure), the government may regulate the monopolist rather than trying to break it up.
The goal of regulation is usually to force the monopolist to charge a price closer to the efficient outcome.
A. Marginal Cost Pricing (The Ideal)
The regulator forces the monopolist to set \(P = MC\). This achieves allocative efficiency.
- Problem: Often, for a natural monopoly, the MC curve is below the ATC curve for relevant outputs. Setting \(P = MC\) would mean \(P < ATC\). The firm would make losses and eventually exit the market. Therefore, the government would have to provide a subsidy to keep the firm running.
B. Average Cost Pricing (The Compromise)
The regulator forces the monopolist to set \(P = ATC\). This ensures the firm covers all its costs (earns normal profit) but eliminates economic profit.
- Benefit: No need for government subsidies, and the price and output are better than the unregulated monopoly outcome.
- Limitation: Since \(P > MC\), allocative efficiency is still not achieved, but the welfare loss is significantly reduced.
3. Encouraging Competition
Governments can reduce market power by actively lowering barriers to entry:
- Removing restrictive licensing requirements.
- Deregulation (reducing rules for new firms).
- Funding research and development (R&D) to help smaller firms compete technologically.
Common Mistake to Avoid: Don't confuse average cost pricing (P = ATC) with marginal cost pricing (P = MC). Marginal cost pricing is allocatively efficient but requires a subsidy for natural monopolies. Average cost pricing avoids subsidies but is still allocatively inefficient.
V. Oligopoly and Collusion (The Cartel)
While monopoly is the simplest case of market power, in the real world, oligopoly (a few dominant firms) is much more common. Oligopolies are highly interdependent, meaning one firm's actions affect the others.
The Problem of Collusion
When oligopolists engage in collusion, they agree to act together to limit competition, often by fixing prices or restricting output. A formal agreement to collude is called a cartel.
- Outcome: A cartel effectively operates like a single monopoly. They collectively produce output where their joint \(MR = MC\) and charge the monopoly price \(P_M\).
- Market Failure: Cartels suffer from the same inefficiencies as monopolies (high price, low output, DWL). This is why antitrust law strictly prohibits cartels.
The Instability of Cartels: Collusion is inherently unstable because individual members have a huge incentive to "cheat" (i.e., secretly produce a little more than their agreed quota to capture a greater share of the high monopoly profit). If many members cheat, the price falls, and the cartel collapses.
Quick Takeaway: Market power, whether held by a single monopoly or a colluding cartel, results in a restriction of output and an increase in price above marginal cost, causing market failure through lost social welfare (DWL).