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14.4 End-of-Chapter Material

In Conclusion

There are very few examples of truly competitive markets. Most firms in the economy possess a certain amount of market power because their product, service, or location is distinctive. This means that most prices in the economy are in excess of marginal cost.

That said, the degree of market power of most firms is relatively small. Canon has some market power for its cameras because Canon cameras are not identical to Nikon, Olympus, or Sony cameras. But the presence of these other manufacturers severely limits Canon’s ability to charge high prices. Your local Thai restaurant has some market power because its food is different from that of other restaurants in the neighborhood. Again, though, this does not mean it can charge very high prices because customers can easily eat at other restaurants instead.

Occasionally, however, firms are so large relative to their markets that they have substantial market power. This distorts prices and output in the economy. Firms with such market power can make a lot of money by restricting their output and charging very high prices. This is where the antitrust authorities come into play. Their task is to identify firms that are abusing their market power in this way. In effect, their job is to try to bring the economy closer to the economists’ ideal world, where markets are competitive, there are no distortions, and all possible gains from trade are realized.

In some cases, though, governments have reasons to create and support market power through patents and copyrights. They do so because the benefits from innovation outweigh the distortions associated with monopoly. Policy in this area is highly contentious because the right balance between encouraging innovation and fostering competition is unclear. Economists and policymakers continue to struggle with this and are likely to do so for years to come.

Key Links

Exercises

  1. Suppose you have two types of beverages: a cola and a beer. Are these products in the same market?
  2. The table in Question 3 shows data for a monopolist who sells a good to four households, each of which buys at most one unit and each of which has a different valuation for the good. The monopolist can produce the good at a marginal cost of $4. The monopolist can discriminate perfectly in its pricing, charging each household its valuation. Fill in the missing elements in the table. How many units should the monopolist produce? How does your answer change if marginal cost is $6?
  3. (Advanced) Looking again at the following table (with marginal cost equal to $4), calculate the marginal revenue. What is its relationship to price? Explain your findings.

    Table 14.2 Price Discrimination by a Monopolist

    Household Quantity Household Valuation Price Total Revenue Marginal Cost Total Cost Profit
    A 1 12 12 12 4 4 8
    B 2 6 6 18 4 8 10
    C 3 4 4 4
    D 4 3 3 4
  4. Write an explanation of the monopoly pricing problem assuming the monopolist sets the price rather than chooses quantity. Why is the outcome the same either way?
  5. Looking at the table in Question 3, if the interest rate increased to 15 percent, would the firm still have an incentive to innovate?
  6. Explain why there is a greater incentive to innovate if the final stage of competition is with a small number of quantity-setting firms rather than price-setting firms.
  7. Why might a merger lead to a price reduction? Why might a merger lead to a price increase?
  8. Suppose that a firm (the incumbent) produces with constant marginal cost at $10 and has a constant (minus) elasticity of demand of 2. What is its profit-maximizing price? Now suppose that a new firm enters the market. The demand curve facing the incumbent firm shifts inward, but suppose that the elasticity of demand does not change. Should the incumbent firm change its price? What happens to the quantity that it sells? Draw a diagram to illustrate this market.
  9. Imagine there is a motorcycle dealer in your neighborhood. You know both the price of the motorcycle set by the dealer and the amount of money the dealer paid for that motorcycle. It turns out that your valuation of the motorcycle is less than the posted price but greater than the cost of the motorcycle to the dealer. Are there gains to trade? Do you think you could convince the dealer to sell the motorcycle to you? If so, is there a deadweight loss? Why might the dealer be unwilling to sell the motorcycle to you?
  10. Plane tickets are often sold at different prices to different people. Is this a form of price discrimination?
  11. Writers of textbooks sometimes make their products available at a price of near zero. Does this mean they are altruists, or are they earning revenue some other way?
  12. If interest rates increase, what needs to happen to patent lengths to maintain incentives for innovation?
  13. In Section 14.3.2 "Market Outcomes When Firms Set Quantities", we looked at the situation when two firms chose quantity simultaneously. Describe the game and the outcome if one firm chose its quantity first and the other one followed. Would the outcome be the same as that discussed?
  14. If you were a judge looking at a prospective merger between Coke and Pepsi, would you be more inclined to support the merger on efficiency grounds or argue against the merger as being anticompetitive?

Economics Detective

  1. If a company invents, patents, and produces a product in the United States and sells the product in China, what type of protection does the company have in China?
  2. If a US company operates in Europe, is it subject to European competition policy?
  3. What legal authority does the European Union have over US firms?

Spreadsheet Exercise

  1. (Advanced) Build a version of Table 14.1 "Calculating the Discounted Present Value of Expected Profits" starting with entries on demand and costs. To do so, use the examples in Chapter 6 "Where Do Prices Come From?" to create demand, revenue, and then marginal revenue. Also use the examples there to create variable cost and marginal cost. Then find the profit-maximizing quantity and price. Using this information, calculate the profit for each year and then calculate the discounted present value of these profits.