Market failure: market power

Obstacles that make it difficult for new firms to enter a market and compete with existing firms. They protect incumbents' market power and profits. Without barriers, supernormal profits would attract new firms, increasing competition and driving profits to normal levels.

The ability of a firm (or group of firms) to influence the PRICE of a good or service. A firm with market power is a PRICE MAKER — it can raise prices above the competitive level, restrict output, and earn abnormal (supernormal) profits in the long run.

A firm with market power produces where MR = MC, but charges a price on the demand curve that is ABOVE MC. Since P > MC, the last unit consumed is valued more than it costs to produce, meaning resources are under-allocated to this market.

1) High market concentration — few firms control most of the market (oligopoly/monopoly). 2) Product differentiation — branding/quality makes products seem unique. 3) Control of essential resources (e.g. De Beers and diamonds). 4) Legal barriers — patents, copyrights, licences.

1) Economies of scale — incumbent's low average cost deters entry. 2) High start-up costs. 3) Legal barriers — patents, licences. 4) Brand loyalty — consumers locked in. 5) Control of supply chains/distribution. 6) Predatory pricing — temporarily cutting prices below cost to drive entrants out.

The loss of total surplus because the firm produces less than the socially optimal quantity. Some mutually beneficial trades don't happen. On a diagram, it is the triangle between the demand curve, MR curve, and MC curve, from the monopoly output to the competitive output.

The firm charges a higher price and sells a lower quantity than in a competitive market. Consumer surplus shrinks — the area above the price line and below demand is smaller. Some of the lost consumer surplus is transferred to the firm as producer surplus (profit); the rest is deadweight loss.

In perfect competition, no single firm can affect the price — all are price TAKERS selling identical products. With market power, firms can set prices above marginal cost, restrict output, and earn supernormal profits because consumers have fewer alternatives.

The incumbent firm produces at such large volume that its average cost is very low. A new entrant, starting small, has much higher average costs and cannot match the incumbent's prices. This makes entry unprofitable and effectively blocks new competition.

When a firm with market power does not minimise its costs because it faces no competitive pressure. Without the threat of rivals, there is less incentive to control waste, innovate processes, or push for productivity. This is also called productive inefficiency from complacency.

Profits above the normal return needed to keep a firm in business. In competitive markets, supernormal profits attract entry and are competed away. With market power, barriers to entry prevent this, so firms can sustain supernormal profits in the long run.

When an incumbent firm temporarily cuts prices below cost to drive new entrants (or small competitors) out of the market. Once competitors exit, the firm raises prices again and recaptures its monopoly power. This is illegal in most jurisdictions.

Without barriers, supernormal profits attract new firms into the market → supply increases → price falls → profits return to normal. Barriers prevent this competitive process, allowing incumbent firms to maintain high prices and profits in the long run.

By making products seem unique through branding, quality, design, or features, firms reduce the substitutability of their product. Consumers become less price-sensitive (demand becomes more inelastic), giving the firm power to charge higher prices without losing all customers.

Draw D (downward-sloping), MR (below D, twice as steep), and MC. Monopoly output at MR = MC. Price read off the D curve at that quantity. Competitive output at D = MC. Shade: DWL triangle between monopoly and competitive output, bounded by D and MC.

ALLOCATIVE: P = MC (right goods produced — value = cost). PRODUCTIVE: min ATC (goods produced at lowest cost). DYNAMIC: innovation over time (R&D, new products, lower costs). X-EFFICIENCY: no waste due to competition; X-INEFFICIENCY = waste from lack of competitive pressure.

X-inefficiency: the firm does NOT minimise costs because there is NO competitive pressure to do so. Managers are complacent, costs are higher than necessary. Occurs primarily in monopolies and protected firms. Not a deliberate choice — it's organisational slack.

Allocative efficiency (P=MC) → no deadweight loss, total welfare is maximised, resources in their highest-valued use. Productive efficiency (min ATC) → society uses fewest resources per unit of output. Together they ensure maximum welfare from given resources. BOTH are achieved in PC long run.

PERFECT COMPETITION — in the LR: P = MC (allocative), min ATC (productive), no X-inefficiency (competition forces cost minimisation). However, PC is NOT dynamically efficient — firms earn only normal profit, so there are no funds for R&D or innovation.

1) Supernormal profits provide FUNDS for R&D. 2) Patents protect returns on innovation (incentive to invest). 3) Schumpeter argued that only large firms with market power have the resources and incentive for breakthrough innovation. 4) 'Creative destruction' drives long-run progress.

Allocatively INEFFICIENT (P > MC). Productively INEFFICIENT (excess capacity, not at min ATC). Some dynamic efficiency (product innovation for differentiation). The 'cost' of these inefficiencies is VARIETY — consumers benefit from choice and product diversity.

STATIC efficiency (allocative + productive) is best in PC. DYNAMIC efficiency (innovation) may be best in monopoly/oligopoly. No single market structure maximises ALL types. This is fundamental: PC sacrifices innovation for low prices today; monopoly sacrifices low prices today for better products tomorrow.

Schumpeter argued that innovation by monopolistic firms DESTROYS existing products/firms but CREATES better ones. This dynamic process drives economic progress. Short-term monopoly is the reward for innovation, and competition from NEW products (not lower prices) is what matters most.

Always discuss the TRADE-OFF. Don't just say 'monopoly is inefficient' — compare WHICH types. Use 'it depends': on the industry, firm's behaviour, time horizon, and regulatory environment. The best answer acknowledges that dynamic gains MAY outweigh static losses (or vice versa) depending on context.

Government laws and regulations designed to promote competition, prevent abuse of market power, and protect consumer interests. Also called antitrust policy. Tools include anti-monopoly legislation, merger regulation, break-ups, and fines for anti-competitive behaviour.

1) Can lower prices for consumers. 2) Increases choice and product variety. 3) Improves efficiency (competitive pressure reduces waste). 4) Merger regulation prevents harmful consolidation before it occurs. 5) Fines deter anti-competitive behaviour.

An industry where the minimum efficient scale is so large relative to market demand that only ONE firm can produce at the lowest average cost. Having two firms would duplicate expensive infrastructure (water pipes, railway tracks, electricity grids), raising costs for everyone.

1) Authorities may lack information to distinguish competitive from anti-competitive behaviour. 2) Regulation is costly and firms may "game" the rules (regulatory capture). 3) Breaking up firms can reduce economies of scale. 4) Nationalisation may cause productive inefficiency (no profit motive).

Breaking it up would RAISE costs because each smaller firm would need its own infrastructure (duplicate water pipes, railway lines). One firm producing for the whole market achieves the lowest average cost. The solution is to REGULATE the monopoly, not break it up.

1) Anti-monopoly legislation — prevents abuse of dominant position. 2) Merger regulation — reviews/blocks mergers that reduce competition. 3) Breaking up monopolies — forces a monopoly to split into smaller firms. 4) Fines — punishes price-fixing, market-sharing, and predatory pricing.

In 2024, the EU fined Apple €1.84 billion for abusing its dominant position in music streaming — Apple prevented Spotify and others from telling users about cheaper subscription options outside the App Store, limiting consumer choice.

When a regulatory body becomes dominated by the industry it is supposed to regulate. Firms lobby the regulator, provide information selectively, or offer jobs to ex-regulators. The regulator ends up serving the industry's interests rather than the public's.

1) Price regulation — set maximum price (often P = AC for normal profit). 2) Rate-of-return regulation — cap the allowed rate of profit. 3) Quality standards — prevent the firm from cutting quality. 4) Nationalisation — state owns and operates the monopoly directly.

To prevent harmful consolidation BEFORE it happens. If two large firms merge, the combined entity may have excessive market power, raise prices, and reduce consumer choice. Competition authorities assess whether the merger would "significantly reduce competition" and can block it.

Supernormal profits fund research and development (R&D), leading to innovation that benefits consumers in the long run. Without the prospect of monopoly profits, firms may lack the incentive to invest in risky new technologies. The goal isn't to eliminate market power but to prevent its abuse.

1) Water supply — one set of pipes serves a region. 2) Electricity grids — one network distributes power. 3) Railway networks — duplicate tracks would be wasteful. 4) Gas pipelines — massive infrastructure with huge economies of scale.

The firm has a natural cost advantage (one set of infrastructure), so competition is inefficient. But without regulation, the firm can charge monopoly prices and earn supernormal profits. Governments must balance: allow the cost efficiency of one firm while preventing price abuse.

Price-fixing is when competing firms secretly agree to set prices at an agreed level rather than competing. It eliminates price competition, keeps prices artificially high, and harms consumers. It is a form of collusion and is punishable by large fines in most countries.

Weigh consumer harm (higher prices, lower output, DWL) against potential benefits (innovation, EoS, R&D). Discuss specific policies (competition law, regulation, nationalisation) and their limitations. Conclude: the goal is to prevent ABUSE while harnessing the benefits of scale and innovation.

FIXED COSTS (FC): costs that do not change with output (e.g. rent, salaries of permanent staff). VARIABLE COSTS (VC): costs that change directly with output (e.g. raw materials, energy, wages of production workers). Total cost = FC + VC.

MC = the change in total cost from producing ONE more unit. MC = ΔTC/ΔQ. The U-shape is due to the law of diminishing marginal returns: initially MC falls (increasing returns to the variable factor), then MC rises (diminishing returns — each extra worker adds less output).

MC intersects ATC at its minimum point. When MC < ATC, ATC is falling. When MC > ATC, ATC is rising. Think of it like grades: if your marginal grade is below your average, your average falls; if above, your average rises.

The LRAC curve shows the minimum average cost at each level of output when ALL factors are variable. It is the envelope of all SR ATC curves. U-shaped because of: economies of scale (falling LRAC), constant returns, then diseconomies of scale (rising LRAC).

1) TECHNICAL: larger machines, specialised equipment, container principle. 2) MANAGERIAL: hiring specialist managers (marketing, finance, HR). 3) FINANCIAL: large firms borrow at lower interest rates. Also: purchasing (bulk discounts), marketing (spreading ad costs), risk-bearing (diversification).

The MES is the smallest level of output at which LRAC is minimised. If MES is very large relative to market demand, only a few firms can operate efficiently → natural oligopoly or natural monopoly. If MES is small, many firms can coexist.

DIMINISHING RETURNS = short-run concept; at least one factor is fixed; adding more of the variable factor eventually yields less extra output. DISECONOMIES OF SCALE = long-run concept; all factors are variable; increasing plant size eventually raises LRAC (communication problems, coordination difficulties, bureaucracy).

As more units of a variable factor (e.g. labour) are added to a fixed factor (e.g. capital), the marginal product of the variable factor will eventually decrease. This applies ONLY to the short run, when at least one factor is fixed.

1) Communication problems — harder to pass information in large organisations. 2) Coordination difficulties — managing many departments/locations. 3) Loss of control — managers can't monitor effectively. 4) Worker alienation — employees feel less connected. 5) Bureaucratic inefficiency.

TR = P × Q (total income from sales). AR = TR/Q = P (revenue per unit = the demand curve). MR = ΔTR/ΔQ (extra revenue from one more unit). For price makers: MR < AR because selling more requires lowering the price on ALL units.

When a firm lowers price to sell one more unit, it gains revenue on the extra unit BUT loses revenue on all previous units (which are now sold at the lower price). The loss on previous units makes MR fall faster than AR. For a linear demand curve, MR has the same intercept but twice the slope.

TR is maximised when MR = 0. At this point, PED = −1 (unit elastic). Above this quantity, MR is positive (elastic range). Below this quantity, MR is negative (inelastic range). Note: profit-maximising firms don't aim for max TR — they aim for MC = MR.

If MR > MC, producing one more unit adds more to revenue than to cost → profit increases. If MR < MC, the extra unit costs more than the revenue it brings → profit decreases. Profit is maximised at the output where MR = MC (no further gain from changing output).

Profit per unit = AR − ATC (the vertical gap between the AR curve and ATC curve at the profit-maximising output). Total profit = (AR − ATC) × Q. This appears as a rectangle on the diagram. If AR > ATC → supernormal profit. If AR = ATC → normal profit. If AR < ATC → loss.

Yes! ALL profit-maximising firms use MC = MR, regardless of market structure. The difference is in the shape of MR: in perfect competition MR = AR = P (horizontal). In monopoly/MC/oligopoly, MR < AR (downward sloping) because the firm is a price maker.

NORMAL PROFIT: the minimum return needed to keep a firm in the industry (AR = ATC). It is an economic cost (opportunity cost of the entrepreneur's time and capital). SUPERNORMAL (abnormal) PROFIT: profit above normal profit (AR > ATC). In competitive markets, supernormal profits attract entry.

A firm should shut down if P < AVC (price is below average variable cost). At this point, the firm cannot even cover its variable costs — it loses MORE by staying open than by shutting down. If AVC < P < ATC, the firm makes a loss but covers some fixed costs, so it should continue in the SR.

Subnormal profit = economic loss (AR < ATC). The firm earns less than normal profit. In the long run, firms making losses will EXIT the industry. This reduces supply, raises price, until remaining firms earn normal profit (AR = ATC). Exit only happens in the LR because FC can't be avoided in SR.

1) Many buyers and sellers. 2) Homogeneous (identical) products. 3) No barriers to entry or exit. 4) Perfect information (all actors know all prices/costs). 5) Firms are price takers (cannot influence market price). Each firm faces a perfectly elastic (horizontal) demand curve.

Each firm is so small relative to the market that it cannot influence price. If it charges above the market price, it sells nothing (consumers buy identical products elsewhere). It has no reason to charge below market price (it can sell all it wants at P). So D = AR = MR = P.

Agricultural markets (wheat, corn) come closest: many farmers, fairly homogeneous product, relatively easy entry/exit, price determined by global commodity markets. Currency markets and some online platforms also approximate PC. True PC is a theoretical ideal rarely seen in practice.

YES. In the SR, if market price is above ATC, the firm earns supernormal profit (the rectangle between P and ATC at the profit-max output). But this CANNOT persist in the LR — high profits attract new entrants, shifting market supply right and pushing price down.

The firm's SHORT-RUN supply curve is the MC curve ABOVE the AVC curve. Below AVC, the firm shuts down (supplies zero). Above AVC, the firm produces where P = MC. The market supply curve is the horizontal sum of all individual firms' supply curves.

If P < ATC but P > AVC, the firm continues producing in the SR (covering variable costs and some fixed costs — better than shutting down and paying all FC). If P < AVC, the firm shuts down immediately. In the LR, loss-making firms EXIT the industry.

In LR: P = MC = min ATC. The firm earns NORMAL profit only (AR = ATC). Entry and exit have adjusted supply until there is no incentive for further movement. The firm is both allocatively efficient (P = MC) and productively efficient (min ATC).

PC achieves: 1) Allocative efficiency (P = MC): the right goods are produced. 2) Productive efficiency (min ATC): goods are produced at lowest cost. 3) No deadweight loss. 4) No X-inefficiency (competition forces cost minimisation). However, PC LACKS dynamic efficiency (no funds for R&D).

Demand rises → market price rises → existing firms earn supernormal profit (P > ATC) → new firms ENTER → market supply shifts right → price falls back down → until P = min ATC again → normal profit restored. Adjustment works in reverse for a demand decrease (exit instead of entry).

1) Single seller (or dominant firm). 2) No close substitutes. 3) High barriers to entry (legal, technical, or strategic). 4) Price maker (downward-sloping demand curve). 5) Can earn supernormal profits in both SR and LR (barriers prevent entry).

A natural monopoly occurs when the MES (minimum efficient scale) is so large relative to market demand that only ONE firm can profitably serve the market. Examples: water supply, electricity grid, railways. Average costs keep falling over the entire range of market demand.

Because high BARRIERS TO ENTRY prevent new firms from entering the market even when profits are attractive. Examples: patents (20 years), control of essential resources, massive economies of scale, legal monopoly (government licence), network effects.

The monopolist produces where MC = MR (profit-maximising output Q*). Then reads the price off the DEMAND curve at Q* (P > MC). The price is higher and output is lower than under perfect competition. The monopolist restricts output to keep prices up.

DWL is the loss of total surplus (CS + PS) caused by the monopolist restricting output below the competitive level. It represents units that would have been traded in a competitive market (where CS > MC) but are NOT produced by the monopolist. Shown as a triangle on the diagram between D, MC, and the monopoly output.

Monopoly: HIGHER price, LOWER output, LOWER consumer surplus, HIGHER producer surplus, NET deadweight loss. PC: P = MC (allocative efficiency), min ATC (productive efficiency), maximum total welfare, zero DWL. Monopoly is allocatively AND productively INEFFICIENT.

1) DYNAMIC EFFICIENCY: supernormal profits fund R&D and innovation (Schumpeter's argument). 2) Economies of scale: may lower costs below what small competitive firms could achieve. 3) Natural monopoly may avoid wasteful duplication of infrastructure. 4) Cross-subsidisation of unprofitable services.

1) Higher prices and lower output → consumer exploitation. 2) Allocative inefficiency (P > MC). 3) Productive inefficiency (not at min ATC). 4) X-inefficiency (no competitive pressure to minimise costs). 5) Income inequality (supernormal profits to shareholders). 6) Rent-seeking behaviour.

1) PRICE REGULATION: force P closer to MC or ATC (reduces supernormal profit). 2) ANTITRUST/COMPETITION POLICY: break up monopolies, prevent mergers. 3) NATIONALISATION: government runs the monopoly. 4) DEREGULATION: remove barriers to encourage competition. 5) Subsidise entry by rivals.

1) Many firms. 2) Differentiated products (branding, quality, location). 3) Low barriers to entry and exit. 4) Each firm has SOME market power (slightly downward-sloping D curve). 5) Non-price competition (advertising, quality). Examples: restaurants, hairdressers, clothing brands.

vs PC: MC has differentiated products (not homogeneous), downward-sloping D (not horizontal), some market power (not price taker). vs MONOPOLY: MC has many firms (not one), low barriers (not high), only SR supernormal profits (monopoly sustains LR). MC is a middle ground.

Downward-sloping: because products are differentiated — some customers prefer firm A's version. Relatively elastic: because there are many close substitutes. If a firm raises price too much, consumers switch to a rival's product. More substitutes → more elastic demand.

SR: the firm maximises profit at MC = MR. If P > ATC → supernormal profit. If P < ATC → subnormal profit (loss). The diagram looks like a monopoly diagram but with a more elastic (flatter) demand curve.

If SR supernormal profit → NEW FIRMS ENTER → each firm's demand shifts LEFT (loses market share) → profit falls. If SR loss → firms EXIT → demand shifts RIGHT for remaining firms. LR equilibrium: D curve is TANGENT to ATC → normal profit (AR = ATC at Q*). But P > MC and Q < min ATC.

In LR, the MC firm produces LEFT of minimum ATC (the tangency point is on the declining portion of ATC). The gap between Q* and the output at min ATC is EXCESS CAPACITY — the firm COULD produce more at lower cost but doesn't because D is downward-sloping. This means productive inefficiency.

Not necessarily! The 'cost' of inefficiency is the PRICE OF VARIETY. Consumers value choice, branding, and differentiated products. The excess capacity and slightly higher prices may be worth it for the diversity of options. Whether this trade-off is worthwhile depends on consumer preferences.

FAILS: Allocative efficiency (P > MC). Productive efficiency (not at min ATC, excess capacity). ACHIEVES: Some dynamic efficiency (product innovation to differentiate). No X-inefficiency in LR (competitive pressure from potential entrants). Normal LR profit (no exploitation).

Non-price competition is key in MC because products are similar but differentiated. Advertising aims to: 1) Shift the firm's demand curve RIGHT. 2) Make demand more INELASTIC (stronger brand loyalty → less price-sensitive consumers). Both increase the firm's ability to charge higher prices.

A market dominated by a FEW LARGE FIRMS (high concentration ratio). Key feature: INTERDEPENDENCE — each firm's decisions affect the others, and they must consider rivals' likely reactions. Products may be homogeneous (oil) or differentiated (cars). High barriers to entry. Examples: airlines, tech, banking.

Each firm must consider the LIKELY REACTIONS of rivals before making decisions on price, output, or advertising. A price cut by one firm may trigger a price war. A price increase might not be followed — you lose customers. This uncertainty makes oligopoly behaviour hard to predict.

1) Economies of scale (huge MES — new entrants can't match incumbents' low costs). 2) High start-up capital. 3) Brand loyalty (years of advertising). 4) Patents and intellectual property. 5) Predatory pricing threat (incumbents may cut prices to drive out entrants). 6) Network effects.

Two prisoners can cooperate (stay silent) or defect (confess). Individually rational to defect, but BOTH are worse off. In oligopoly: firms could cooperate (keep prices high) but each has an incentive to undercut (defect). If both undercut → price war → both worse off. Shows why collusion is unstable.

A Nash equilibrium is an outcome where no player can improve their payoff by unilaterally changing their strategy (given the other players' strategies). In the prisoner's dilemma, both defecting is the Nash equilibrium — neither gains by switching alone. Named after John Nash.

A payoff matrix shows the outcomes (payoffs) for each combination of strategies chosen by two players. Rows = Player 1's strategies. Columns = Player 2's strategies. Each cell has two numbers: (Player 1's payoff, Player 2's payoff). Used to identify dominant strategies and Nash equilibrium.

COLLUSION: firms agree (explicitly or tacitly) to limit competition — fixing prices, dividing markets, or restricting output. A CARTEL: a formal agreement among firms to collude (e.g. OPEC). Illegal in most countries. Tacit collusion: no explicit agreement but firms follow a price leader.

1) Incentive to CHEAT: each member gains by secretly lowering price while others maintain high prices. 2) Difficult to monitor compliance. 3) Different cost structures → disagreement on price levels. 4) New entrants attracted by high prices. 5) Legal enforcement against cartels. Classic prisoner's dilemma!

Assumes rivals MATCH price cuts but DON'T match price increases. Above the current price, demand is elastic (raise P → lose many customers to rivals). Below the current price, demand is inelastic (cut P → rivals also cut, so few extra customers). This creates a KINK in the demand curve and a DISCONTINUITY in MR, explaining price rigidity.

Charging different prices to different consumers for the SAME product, where the price difference is NOT cost-justified. Conditions: 1) Market power (price maker). 2) Ability to segment the market (identify groups with different willingness to pay). 3) Prevention of resale (no arbitrage).

1) STUDENT DISCOUNTS (cinemas, trains) — 3rd degree PD based on age/status. 2) PEAK vs OFF-PEAK pricing (electricity, flights) — based on time of use. 3) PERSONALISED online pricing (different prices based on browsing history) — approaches 1st degree PD.

A PC firm is a PRICE TAKER — it cannot set different prices because: 1) Products are homogeneous (no reason to pay more). 2) Perfect information means consumers know all prices. 3) No market power (firm faces horizontal demand). Only firms with market power can price discriminate.

The firm charges each consumer their MAXIMUM WILLINGNESS TO PAY. ALL consumer surplus is extracted and converted to producer surplus. Output may actually be higher than single-price monopoly (up to P = MC). Very rare — approached by auctions, car dealers, personalised pricing algorithms.

The firm segments the market into IDENTIFIABLE GROUPS with different PEDs and charges each group a different price. INELASTIC group → HIGHER price. ELASTIC group → LOWER price. To maximise profit: set MR₁ = MR₂ = MC across groups. Most common and most tested type.

The firm charges different prices based on QUANTITY purchased — consumers SELF-SELECT into pricing tiers. Examples: bulk discounts (buy 3 for price of 2), tiered electricity rates (first 100kWh cheaper), economy vs business class. The firm doesn't need to identify groups — consumers reveal preferences.

1) Higher output (price-sensitive consumers served at lower price → less DWL). 2) Cross-subsidisation (profits from high-P group fund services for low-P group). 3) Equity (students/elderly get lower prices). 4) Firm survival (high-FC industries like airlines cover costs). 5) 1st degree achieves allocative efficiency.

1) Consumer surplus is reduced (firm extracts more surplus). 2) Inelastic group pays MORE — those with fewer alternatives are exploited. 3) Admin costs of segmenting and preventing resale. 4) Potential for exploitation by firms with significant market power.

CONTEXT matters! PD by a pharma company (cheaper drugs in developing countries) is socially beneficial. PD by a monopoly exploiting captive consumers is harmful. Always: 1) Identify who gains and who loses. 2) Consider the overall welfare effect (is total output higher?). 3) Assess the firm's market power.