1. Degrees of Market Power and
Policy
April 12, 2013

2. Announcements
• Problem Set 2 due Monday!
• TAs will go over in section next week.

3. Last Class
• Studied how to derive monopoly profits in-
depth.
– Find Q using MR and MC
– Calculate profits using ATC

4. Learning Goals for Today
• Show how price discriminating monopoly
surplus differs from generic monopolies.
• Describe how oligopoly and monopolistic
competition differ from monopoly.
• Offer policy recommendations for dealing with
monopolies.

5. Recall: General Form of Monopoly
Problems
• Given:
– Fixed Costs
– Production Function: Generally Q=KaL1-a
– Variable Costs: w for L and r for K
– Demand
• Derive:
– TC, ATC, MC given Fixed Costs, Prod Func, and Var
costs
– MR given Demand
– Profit-max. condition and Profit given the above
– Surplus

6. Price Discrimination
• Thus far we have assumed all buyers charged the same.
• Price Discrimination: The practice of charging different buyers
different prices for essentially the same good.
• How does price discrimination affect output and profits?
P P
CS
DWL
PS PS
MC=ATC MC=ATC
MR D D
Q Q
Perfectly Price
Single-Price Monopolist
Discriminating Monopolist

7. Example: ``Hurdle.’’
• Rebates: The assumption is that people with high reservation
prices are wealthy and that the opportunity cost of their time
is too high to be bothered to fill out the paperwork to get the
rebate.

8. Which of the following is price
discrimination?
A. Efficient
B. Good
C. Inefficient
D. Bad
E. Can’t Say

9. Other types of firms with market
power
• Are there firms that have some, but not
complete market power?
• Think in terms of the assumptions we made
for perfect competition. Which are violated
under what conditions?
– All firms sell the same (really the same!) product.
– There are many buyers and sellers.
– There are no costly barriers to starting a business.
– Both consumers and firms are well-informed.

10. Monopolistic Competition
A market in which a large number of
firms sell products that are close (but
not perfect) substitutes.
Examples?
Have some ability to raise price in the short-run, but free entry will
lead to zero (economic) profits in the long run.
Most important strategic decision: how to differentiate products
from rivals’ products?
Markup

11. Oligopoly
A market in which a small number of large firms sell
products that are either close or perfect substitutes.
Examples?
Usually arise because of cost advantages of being large—
thus, no presumption that free entry will drive profits to
zero, but no guarantee that oligopolists will earn zero profits.

12. Consider two oligopolists. If one is
charging the price a monopoly would
choose, the other should charge which
of the following to profit-maximize?
A. A higher P
B. The same P
C. A lower P

13. Government Regulation
• When we think about government regulation, we primarily
think about regulation of natural monopolies. Why?
• Five sources of market power
1. Exclusive control of inputs
2. Patents and copyrights
3. Government licenses
4. Economies of Scale Can sometimes be thought
of as the same thing—both
5. Network Economies
give rise to natural
monopolies

14. Government Regulation
• State ownership of natural monopolies.
– Only one private company can survive—average costs are
too high when multiple firms are in the market.
– Solution: government takes over, sets P=MC and then
absorbs any loss (paid for by taxes).
– Potential problems:
• Will government-run firm be cost efficient?
• Where do tax revenues come from?

15. Government Regulation
• State regulation of natural monopolies (common in the U.S.).
– Most states regulate electric utilities, natural gas providers,
and cable television companies.
– Cost-plus regulation: figure out the monopolists explicit
costs and then allow them to charge that plus some
markup.
– Problems
1. Often difficult to determine a firm’s costs
2. Blunts firm’s incentive to cut costs.

16. Government Regulation
• Allow private firms to bid for the right to provide the goods
and services that would be provided by a natural monopoly.
– Competition maintains firms’ incentives to cut costs.
– Problems: may not be feasible in cases where production
requires a large fixed investment in capital equipment—
how do you transfer the equipment if another firm wins
the bid?
– Many cities increasing considering or using private
contractors to provide garbage collection, fire protection,
police protection, EMS, landscaping etc.

17. Ignore Monopolies?
• Price discrimination implies that monopolists are making
much of their profit from buyers who are willing and able to
pay higher prices.
• Much of monopolists’ profits goes to the federal government
via the corporate income tax, and this money can be used to
fund a variety of government programs.
• On the other hand, imperfect price discrimination will not
lead to an efficient outcome—so we still need to be
concerned.

18. For next time
• Finish problem set
• Try to grasp Nash equilibria from the reading
• We will begin with oligopolist game