Week 6A

Week 6A - COMM/FRE 295 October 12, 2010 Market Power and...

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COMM/FRE 295 October 12, 2010 Market Power and Monopoly
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Topics Examined • Concept of market power • “Rule of thumb” pricing – inverse elasticity rule for price setting • Lerner Index for measure of market power • Allocating production across two plants • Reasons for monopoly • Natural monopoly • Social cost of monopoly (and rent seeking) • First, second and third degree price discrimination
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Market Power • Price-taking perfectly competitive firms produce according to a supply schedule • A monopolist controls the entire demand curve and does not have a supply schedule • Most firms have some competitors and have some market power, so are in between competition and monopoly • Market power a firm’s demand slopes down • The principles of optimal price setting is the same for a monopolist and a firm with market power
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Elasticity and MR Connection • Suppose a firm with market power lowers price. What will happen to revenue? Rev = PQ(P) – Increase if demand is elastic – Decrease if demand is inelastic Elastic demand Q rises proportionately more than decrease in P revenue will increase positive marginal revenue (MR) Inelastic demand Q rises proportionately less than decrease in P revenue will decrease negative marginal revenue (MR)
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Now in Reverse • Raising price will decrease revenue if demand is elastic (equivalently, MR is positive) • Raising price will increase revenue if demand is inelastic (equivalently, MR is negative) • Raising price will decrease cost (because less is sold) • Therefore, raising price may increase or decrease profits if demand is elastic (MR positive) • Therefore, raising price must increase profits if demand is inelastic (MR negative)
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Price only where Demand is Elastic • If demand is inelastic price should be increased because revenues will increase and production costs will decrease (less is sold) • Continue to increase price while demand is inelastic in order to continue increasing profits • Raising price eventually causes demand to switch from inelastic to elastic • Now revenue is going down and costs are going down as price is continually raised • Optimal price must be in the elastic region
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Inelastic Region Negative MR Elastic Region Positive MR Demand MR Demand shows average revenue (AR). MR < AR because each additional Q contributes less to revenue due to a declining price
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Rule of Thumb Pricing • We have R(Q) = P(Q)Q; • Chain rule MR = dR(Q)/dQ = P(Q) + Q[dP(Q)/dQ] • Factor P out of MR = P + (dP/dQ)Q: MR = P[1 + (dp/dQ)(Q/P)] • Notice that (dp/dQ)(Q/P) = 1/E where E is the elasticity of demand • So MR = P[1 + 1/E]
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Rule of Thumb Pricing, Cont’n • Profit maximization MR = MC P[1 + 1/E] = MC P – MC = -P/E (P – MC)/P = -1/E • This is “rule of thumb” for optimal pricing; remember the formula (not the actual derivation)
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Interpretation of the Rule (P – MC)/P = -1/E tells us that a manager
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Week 6A - COMM/FRE 295 October 12, 2010 Market Power and...

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