Market power and other market imperfections

Overview

Market power, productive inefficiency and barriers to entry.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is market power, and how does a firm holding it behave differently from a firm in a competitive market?

   Model answer

   Market power is the ability of a firm to influence the price at which it sells rather than having to accept the price set by the market. A competitive firm treats price as given and expands output while price covers marginal cost. A firm with market power faces a downward-sloping demand curve of its own, so selling more requires a lower price; it therefore restricts output below the competitive level and sets a price above marginal cost, and that gap is the source of the misallocation.

2. 2

   Why does market power cause allocative inefficiency?

   Model answer

   Allocative efficiency requires price to equal marginal cost, so that the value consumers place on the last unit equals the cost of producing it. A firm with market power holds output back to a level where the price consumers are willing to pay exceeds marginal cost. Units that consumers value more than they cost to produce are therefore never made. The gap between price and marginal cost is the signature of the inefficiency, and the units forgone are the source of the welfare loss.

3. 3

   Describe in words the welfare loss caused by a dominant firm restricting output, naming the axes.

   Model answer

   Put price and cost in £ on the vertical axis and quantity per period on the horizontal. Draw a downward-sloping demand curve and an upward-sloping marginal cost curve. The competitive outcome is where the demand curve crosses marginal cost, at Qc, with price equal to marginal cost there. A firm with market power supplies a smaller quantity Qm and charges a price above marginal cost. Over the range Qm to Qc the demand curve lies above marginal cost, and the triangle enclosed between them measures the community surplus lost because those units are not produced.

4. 4

   How is consumer surplus affected when a dominant firm raises price above the competitive level?

   Model answer

   Consumer surplus falls for two distinct reasons. On the units still bought, consumers pay more, so a rectangle of surplus is transferred from consumers to the firm as extra profit; that part is a redistribution rather than a loss to society as a whole. On the units no longer bought, the surplus consumers would have enjoyed simply disappears, and so does the producer surplus on them. This second part is the deadweight welfare loss.

5. 5

   Explain why part of the effect of market power is a transfer and part is a loss.

   Model answer

   The higher price on units still traded moves surplus from buyers to the firm, so society's total is unchanged even though the distribution has shifted, and judging that shift depends on whose welfare is weighted more heavily. The units no longer produced are different: the benefit consumers would have received and the surplus producers would have earned on them accrue to nobody at all. That portion is a genuine reduction in community surplus, and it is what economists mean by deadweight loss.

6. 6

   What is productive inefficiency, and why might a firm with market power display it?

   Model answer

   Productive inefficiency means producing at a higher cost per unit than is technically necessary. A firm insulated from competition faces less pressure to control costs, so it may tolerate overstaffing, weak cost discipline and slow adoption of better methods, sometimes described as organisational slack. Resources are then wasted even at the output level chosen. Competitive pressure normally removes such slack, because a firm carrying unnecessary costs is undercut by rivals who do not.

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