2.11 Market failure - market power

Market structures compare how firms face competition.

Start with the number of firms, product similarity, entry barriers and information; these features determine the market model before any diagram is drawn.

Example

A local bakery market has many sellers and differentiated products, while a regulated electricity grid has few suppliers and high entry costs.

Classify the structure from evidence, then predict pricing power, output and efficiency.

A label such as ‘large firm’ does not by itself prove monopoly power; contestability and substitutes still matter.

Structure map: perfect competition—many firms, free entry, homogeneous product; monopoly—single or dominant firm, high entry barriers, no close substitutes; oligopoly—few large firms, high barriers and strategic interdependence; monopolistic competition—many firms, free entry and differentiated products. Classify from the full feature set, not firm size alone.

A rational producer compares marginal benefit with marginal cost.

Profit is maximized where the next unit adds no more revenue than cost, subject to the firm’s demand, technology and legal constraints.

Example

If a firm’s marginal revenue is $12 and marginal cost is$9 at the current output, expanding output can raise profit until the comparison reverses.

Use MR=MC as a decision rule, then check whether the firm can actually sell the extra output.

Rational behaviour is a model assumption, not a claim that every manager has perfect information or identical goals.

Profit $=TR-TC$. Marginal values are changes per extra unit: $MR=\Delta TR/\Delta Q$ and $MC=\Delta TC/\Delta Q$; profit is maximized where $MC=MR$ with MC rising through MR. At that output, $AR>AC$ gives abnormal profit, $AR=AC$ normal profit and $AR<AC$ a loss; total profit is $(AR-AC)\times Q$. Calculate $AR=TR/Q$ and $AC=TC/Q$ from data when needed.

Market power is the ability to influence price. A perfectly competitive firm is a price taker, so market price fixes a horizontal firm curve $P=D=AR=MR$; imperfectly competitive firms face downward-sloping demand and have varying price-making power.

The competitive firm maximizes profit where rising $MC=MR=P$. At that output, $AR>AC$ gives abnormal profit, $AR=AC$ normal profit and $AR<AC$ a loss in the short run. Free entry and exit remove abnormal profit in long-run equilibrium.

Efficiency

The competitive market is allocatively efficient when $P=MC$, equivalently $MB=MC$, so community surplus is maximized under the model. Label the market equilibrium separately from the individual firm's horizontal demand curve.

Do not use a monopoly patent example to teach the perfect-competition Objective. Price-taking requires the market assumptions, and $MC=MR$ identifies output while AR versus AC identifies profit.

A high market share can be temporary; evidence of barriers and switching costs is needed before inferring durable power.

A monopoly faces the market demand curve.

With one dominant supplier, the firm chooses output where MR=MC and then reads the highest price buyers will pay from demand.

Example

If demand is P=20−Q and MC=4, the profit-maximizing output solves MR=4, then price is found from demand rather than set equal to MC.

Separate the output decision from the price read-off, and compare the result with the competitive benchmark.

A monopoly is not automatically a public firm, and natural monopoly conditions depend on cost structure, not simply on being the only seller.

A monopolist maximizes at $MR=MC$ and reads price from AR/demand. If $P=AR>MC$, output is below and price above the competitive $P=MC$ quantity, creating allocative inefficiency and welfare loss. Abnormal profit, normal profit or loss depends on AR relative to AC at that output. A natural monopoly has falling average cost across the relevant market demand because one large supplier can exploit economies of scale more cheaply than multiple firms.

Oligopoly decisions are interdependent.

A few firms must anticipate rivals’ reactions, so price, advertising and output choices can create strategic outcomes rather than a single independent optimum.

Example

If one airline cuts fares, competitors may match the cut; the first firm’s gain depends on the response, not only on its own demand curve.

State each firm’s action, expected response and resulting payoff before judging cooperation or competition.

Oligopoly does not guarantee collusion; outcomes range from aggressive rivalry to tacit coordination and depend on evidence.

Collusive oligopolists coordinate and may act like a monopoly; non-collusive firms choose independently while anticipating rivals. Interdependence creates price-war risk, incentives to collude and incentives to cheat on an agreement. A payoff matrix records each firm's outcome for paired strategies and reveals dominant strategies or unstable cooperation. Firms use price and non-price competition. A concentration ratio is the combined market share of the largest stated number of firms; higher concentration suggests, but does not prove, greater power.

Monopolistic competition combines rivalry with product differentiation.

Many firms can enter, but branding or design gives each a downward-sloping demand curve and limited short-run price discretion.

Example

Two cafés may charge different prices because location and taste differentiate them, yet new cafés can enter if profits persist.

Link product differentiation to short-run power, then use entry to explain why long-run economic profit is pressured.

Product variety is not proof of perfect competition; each firm still faces its own demand and costs.

In both short and long run, choose $MR=MC$ output and read price from AR. Short-run entry barriers can permit abnormal profit, normal profit or loss. Free entry and exit shift each firm's demand until long-run normal profit where $AR=AC$ at the chosen output. Because product differentiation leaves downward-sloping AR, $P>MC$ and spare capacity imply allocative inefficiency; many substitutes make demand more elastic and inefficiency generally smaller than monopoly while variety is greater.

Market power can fund innovation but also create allocative loss.

The same barrier that supports research or network investment may let a firm restrict output, raise price or weaken consumer choice.

Example

A software platform may use profits to improve security while its closed ecosystem raises switching costs for users.

Evaluate both the dynamic benefit and the static cost, specifying who gains, over what time horizon and under which evidence.

There is no automatic sign for welfare: innovation claims need evidence, and deadweight loss is not the only criterion.

Government may use legislation and regulation, government ownership or fines when significant market power is abused. The objective is to constrain harmful conduct or outcomes rather than punish firm size by itself.

Legislation can prohibit collusion or anti-competitive exclusion; regulation can control price, quality or access; government ownership can place a natural-monopoly service under public control; fines deter and penalize proven breaches.

Example

A utility regulator may cap a natural monopoly's price and set service standards. Competition law may fine firms that coordinate prices, provided investigation establishes the prohibited conduct.

Evaluate enforcement cost, regulatory capture, information gaps, incentives to invest, service quality and consumer outcomes. Merger control or structural separation may be related policies, but the required syllabus responses are legislation/regulation, ownership and fines.

A policy that lowers price can also reduce investment or quality; the diagram alone cannot settle the evaluation.