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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.


Figure 6

Graph of price-setting firm showing the dead weight loss to society from its market power.


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 the results.


Table 1

Lost buyers surplus = -A - B
Gained sellers surplus = +A - C
Deadweight loss = 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 power.

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.


This is a good time to start, or review, GFE24.


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.