Tutorial 10: Firms With Market Power (cont.)
The Social Cost of Market Power
A perfectly competitive market delivers the greatest social
surplus. To review, social
surplus is the sum of buyers and sellers surplus. Buyers
surplus is the difference between the actual price paid
and a buyer's reservation price. It is a measure of how
much better off a consumer is from buying a good or service
at a price below his reservation price. Sellers surplus
is the difference between the actual price paid and a seller's
reservation price. It is a measure of how much better off
a producer is from selling a good or service at a price
above her reservation price.
If it takes a perfectly competitive market, where firms
have no market power, to maximize social surplus, what happens
to it in a market where firms have market power?
In Figure 6 we see the model of a firm with price setting
power. The firm maximizes economic profit by producing an
output, Qm, of 3000 units/t and charging a price,
Pm, of $70 per unit. [Do you know why?]
Now we can use this model to compare the price-setting firm's
output and price to the competitive market equilibrium output
and price. In so doing we can see what society loses by
having a price setting firm produce the good.
Suppose this firm is a "multi-plant" monopoly,
that is, it has several production facilities scattered
about, all of which have the same production costs. The
firm's MC line would then be the sum of all the individual
plants's marginal cost curves. If this price-settiing firm
is broken up by the government into seperate sellers, then
MC1 becomes the market supply line and D1 becomes the market
demand line... The intersection of MC1 and D1 would then
reveal the competitive market equilibrium price,
Pc, to be about $55 per unit and the equilibrium
output, Qc, to be about 4500 units/t.
Thus, moving from a competitive market to
one where firm's have market power, output drops from about
4500 to 3000 units/t. On the other hand, price rises from
about $55 to $70 per unit. When price rises, buyer surplus
is reduced by an amount equal to the shaded areas labeled
A and B in Figure 6. Buyers surplus drops
because price increases and because output decreases.
Sellers surplus, on the other hand, is increased by an amount
equal to area A (because price increases)
but is reduced by an amount equal to area C (because
output decreases). Table 1 below summarizes and totals
||-A - B
||+A - C
||B + C
The loss to society of not having goods and
services produced in perfectly competitive markets is called
deadweight loss. It measures the sum of the changes
to buyers and sellers surplus when firms develop market
Obviously we can view the loss of social surplus
as a cost of market power. But what are the benefits?
Well, perfectly competitive firms produced identical
products, and firms with market power produce differentiated
products. There is more choice in the latter type of market
arrangement than in the former, and having choice is usually
perceived as a benefit.
Now we have learned of the social cost of allowing firms
to develop market power. We used the model of a price-setting
firm to measure the size of the lost social surplus. Balanced
against this loss, however, we need to keep in mind that
society does gain by having a variety of goods, though perhaps
all quite similar, from which to choose.
If, however, society decides the loss of social surplus
outweighs the gain from product variability, then it may
choose to have the government grant monopoly status to the
firm and regulate its price and output. How the government
can go about regulating market power is discussed next.