Market Power in Practice

  • We’ve established some theory, now we can begin to look at how it can be applied in practice
    • Market power is a continuous measure, not discrete
    • All firms have some level of market power, even if it’s so small we ignore it
    • In practice, we tend to define some threshold of market power that is worth caring about
  • Graphical example

Consider two separate markets where two distinct firms hold a monopoly and face the same constant marginal cost curve.

  • The key difference between the two firms is that Firm B faces a more elastic demand curve than Firm A (remember that a flatter curve = more elastic)

Claim: more elastic consumers pay a lower price

  • From the graph, we saw that Firm A charges price \(P_1 = \$16\) and Firm B charges price \(P_2= \$12.50\). Additionally, the perfectly competitive price is equal to marginal cost (\(P_c\) = $10) for both firms.
  • To prove our claim, first, we can find the Lerner index for both firms to find which firm has more power in the market:

\[ \lambda_1=\frac{P_1-P_C}{P_1} = \frac{16-10}{16}=\frac{3}{8} \]

\[ \lambda_2=\frac{P_2-P_C}{P_2} = \frac{12.5-10}{12.5}=\frac{1}{5} \]

  • Next, we can use our simplified equation for the Lerner index to solve for the elasticity of demand for both markets:

\[ \lambda_1=\frac{1}{|\eta_1|} \Rightarrow |\eta_1|=\frac{8}{3} \]

\[ \lambda_1=\frac{1}{|\eta_2|} \Rightarrow |\eta_2|=5 \]

If only one case can be prosecuted, which case would it be?

  • Suppose \(Q_c\) where \(D_1=MC\) and \(D_2=MC\) are same across two markets.
  • The social welfare loss loss is greater in market 1 than in market 2.
  • This means that it may be socially optimal to press charge on firm 1 operating in market 1 if only one case can be prosecuted due to antitrust enforcement cost (each case takes on average 24 months and costs on average $200,000-$250,000).

Excess Profit

  • Along with Lerner indices, excess profit can be helpful in measuring market power

    • Excess profit – firms earning greater return on its resources than necessary
    • Excess profit – more entrants into the market
    • If we do not observe entrants over time, we expect there to exist some form of barrier to entry (and some degree of market power for the firm enjoying excess profit)
  • Accounting data is easy to collect; however, this data is not equivalent to economic profit

  • For the purposes of this class, we will calculate economic profit by including depreciation and opportunity cost

    \[ \Pi^e = p\cdot q - TC(q)-D-\gamma \]

    • D is economic depreciation of capital stock
    • \(\gamma\) is the opportunity cost of the asset (or, in the case of a firm supplying a good, \(\gamma\) is the opportunity cost of producing q units)
    • \(D\) and \(\gamma\) are very difficult to measure in practice