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Tutorial 10: Firms With Market Power (cont.)

 

The Price-setting Firm's Supply Curve

The perfectly competitive firm faces an upward-sloping supply curve equal to most of its marginal cost curve. That's because it responds to the market established price when it sets the profit-maximizing level of output. Firms that have the ability to set their own price do not respond to a market set price, but determine both quantity and price simultaneously. As a result, the price-setting firm has no supply curve. For such a firm there is no unique one-to-one relationship between price and the quantity produced. But don't take my word for it, find out for yourself...

 

Now it's time to "do the thing".

Click on the following link to download the Price-setting Firm Workbook. Work through Question 3. This will help you discover why there is no unique supply curve for a price-setting firm. 

Return here when you have finished.

Need help downloading the Excel file?

 

This is a good time to start, or review, GFE 22, question 2.

 

A Source of Market Power Top of page.

At the start of this Tutorial the term "Market Power" was used somewhat vaugely to describe a firm that could set its own price for its product, one that didn't take the market price as given. How high a firm could set price above marginal cost depends on the size of the gap between marginal cost and demand at the profit maximizing level of output. So how much market power a firm has depends on how much of a "markup" a firm has on its product.

After a bit of mathemagics we were able to show that the size of the firm's markup over marginal cost (as a percent of price) depends on price elasticity of demand. So price elasticity of demand for the firm's product can be used as a pretty good measure of the degree of market power enjoyed by a firm.

As mentioned in part b, the size of this markup is inversely related to price elasticity of demand for the firm's product. Thus, firm's facing a perfectly elastic demand have no market power -- in the long run the price charged is equal to the marginal cost of the last unit produced. As buyer responsiveness to a price increase falls, however, the market power wielded by a firm rises. That is why this "markup", 1/Ep, refered to as the "Lerner Index", is used as one measure of the market power of a firm in antitrust cases.

Good examples of the importance attributed to this source of market power are found in your textbook author's discussion of two cartels -- one successful and one not -- OPEC (the Organization of Petroleum Exporting Countries) and CIPEC (the French acronym for International Council of Copper Exporting Countries). [Read PR pages 465 - 467.] To sum up the story, OPEC faces a relatively inelastic demand for oil. There are few substitutes for crude. As a result, it has more market power in that it can keep the price of crude oil much higher than the marginal cost of pumping it out of the ground and delivering it to exporters. CIPEC, on the other hand, faced a relatively elastic demand for copper because there are many more substitutes for copper. It had (past tense) less market power because buyers could easily find alternatives.

 

This is a good time to start, or review, GFE 22, question 3.

 

Market Power in the Short Run and in the Long Run Top of page.

Entry blocked

In part b of this Tutorial we looked at a case where the market was dominated by a single firm that produced a product for which there was no close substitute. The firm in that example earned an economic profit of $55,000. What would happen to this firm's economic profit in the long run? Well, if it were in a perfectly competitive market, one with no barriers to entry, other firms would enter the market, produce an identical product, and force price down to where the economic profit is reduced to zero. But what if entry to the market is blocked. Then no firms could enter and this firm would enjoy its economic profit in perpetuity -- everything else unchanged. Such a firm is referred to as a monopoly, a single seller of a product. A monopoly's ability to successfully block other rivals can come from a number of sources.

One source of blocked entry into a market stems from economies of scale discussed in Tutorial 8d. A firm enjoying economies of scale as it expands its production facilities can have lower average total costs than a firm producing just a small amount of output. Another source of blocked entry into a market stems from a firm's ownership of resources needed to product a product. Suppose a producer of a product that uses nickel in its manufacture also owns most of the world's nickel mines. Other firm wishing to produce a similar product must buy the ore from the mine owner. That gives the resource owner a cost advantage on its output. Ownership of a patent protects a producer from rivals for seventeen years. The government can also grant a firm monopoly status, wherein only that firm may sell the product. Examples of this are easy to come by today. Your local electric utility may still have a license to be the only provider of your electricity.

 

Some barriers to entry

But what if the firm had no such protection from rivals? If there are only a few barriers to entry what would happen to its economic profit in the long run? With only a few barriers to entry other sellers would move into the market and produce a similar product. How would this affect the firm in our example?

Let's start to answer that question by reviewing one important fact about the demand for this firm's product. Unlike sellers in a perfectly competitive market, firms with market power produce a product that is slightly different, or, at least differentiated, from the product produced by their rivals. That is, the firm faces a demand curve that is for its own differentiated product. For example, we can use this model to illustrate the demand for Levi jeans, or Coke, or Subarus. We don't use it to model the demand for all jeans, all soft drinks, or all cars. The products in each category are too different, or at least they appear to be to buyers.

The other important difference in this model is that, unlike the perfectly competitive firm, this price searching firm has no supply curve. And, because the firm is the industry (due to the way demand is narrowly measured), there is no industry supply curve either.

So when other firms enter the market, producing a similar product, this raises the price elasticity of demand for this firm's product because there are more substitutes now available. At the same time, our happless firm will lose customers to the new rivals, and watch helplessly as its demand drops and its economic profit get smaller. Figure 4 illustrates these two simultaneous events.

 

Figure 4


Graph showing drop in market demand for price-setting firm's product and the impact on price, output, and profit.

 

As new firms enter the demand faced by our existing firm becomes more elastic and at the same time drops to D1. Economic profit falls to $28,000 (from it original level of $55,000). This process continues until economic profit is driven to zero, as illustrated in Figure 5. Graphically, the firm's profits are zero when the demand line is just tangent to the average total cost curve at the profit-maximizing level of output.

When econolmic profit is zero no firms have an incentive to enter the market and this firm has no incentive to leave the market. When economic profit is zero, the firm is said to be in long-run equilibrium.

 

Figure 5


Graph showing price-setting firm earning zero economic profit at its profit-maximizing level of output and price.

 

NOTE: When you work on the Questions in the Excel workbook below, remember that immediately after you increase the number of firms in the market, you must reduce the firm's demand. These are simultaneous events in the real world, but you must complete them in two steps in this model...

 

Now it's time to "do the thing".

Click on the following link to download the Price-setting Firm Workbook. Work through Questions 2, and 4 - 7. This will help you improve your understanding of how a price-setting firm responds to changes in market conditions in both the short run and the long run.

Return here when you have finished.

Need help downloading the Excel file?

 

This is a good time to start, or review, GFE 23.

 

The primary goal of a capitalist free-market economy is to create an institution that allows a large number of buyers and sellers to get together in order to engage in mutually beneficial exchange. If such an institution is created, then buyers and sellers, acting only in their self interest, will generate the greatest good for society. Indeed we saw that institution, what we call markets, first described in Tutorial 2 and learned there that the perfectly competitive market modeled in Tutorial 9 generates the largest social surplus.

But firms operating in a perfectly competitive market have no market power. They also produce identical products -- pretty boring! Although we gain some product variation by having fewer firms produce and sell a good, what does the market power enjoyed by these firms cost society? That is the goal of the next part of Tutorial 10.