Review Questions

1. When does a firm have market power?

   A firm that can influence the price at which it sells its product holds market power.

2. Name and describe three barriers to entry to a market.

   Industries with market power have barriers to entry that prevent new firms from entering the market:

   1. Natural monopolies—or markets in which it is efficient for a single firm to produce the entire industry output—serve as effective barriers to entry to other firms.

   2. A switching cost makes it less likely a consumer will switch from one business or product to another, since the consumer will have to give up something in order to make the switch.

   3. Differentiation among products creates an imperfect substitutability across otherwise similar products. As a result, new entrants to the market cannot gain customers simply by selling their product at a lower price.

   4. A firm’s control of key inputs (absolute cost advantage) also will prevent entry into the market.

3. What are the characteristics of a natural monopoly? Why is it efficient for society for a natural monopoly to produce all the output of an entire industry?

   Natural monopolies face economies of scale at all output levels. This means that the larger the firm is, the lower its average total costs. Splitting industry output among different firms would increase average total costs, making it most efficient for one firm to produce the entire industry output.

4. Describe the connection between the slope of the demand curve for a good and a firm’s marginal revenue.

   Just as the demand curve shows the relationship between a good’s price and its quantity, the marginal revenue curve shows the relationship between a good’s marginal revenue and its quantity. The marginal revenue curve of a linear demand curve is also very similar to a demand curve on other dimensions: Its vertical intercept is identical, and its slope is twice the slope of the demand curve.

5. What is the profit-maximizing output level for a firm with market power?

   A profit-maximizing firm produces where marginal revenue equals marginal cost.

6. Compare the consumer and producer surplus of perfectly competitive firms with that of firms with market power.

   A perfectly competitive firm faces a market price equal to its marginal cost, and thus does not earn producer surplus. A firm with market power is able to price above its marginal cost; as a result, it earns producer surplus, at the expense of some of the consumer surplus that would benefit buyers under perfect competition.

7. Why does the profit-maximizing strategy of a firm with market power create a deadweight loss?

   The deadweight loss represents the inefficiency of market power: There are consumers who demand the product at a price above its marginal cost but below the higher price set by the firm with market power. The resulting loss in surplus from these consumers who do not purchase the product under monopoly is the deadweight loss.

8. Why do firms with market power have only demand—and not supply—curves?

   Firms with market power face a set of profit-maximizing prices and quantity combinations, but these combinations do not, strictly speaking, form a supply curve. These price-quantity combinations depend on the firm’s demand curve, while a supply curve by its formal definition exists independent of its associated demand curve.

9. Firms with market power respond differently to changes in consumers’ price sensitivity than do perfectly competitive firms. Explain why this is true.

   In perfect competition, suppliers’ production decisions are independent of the price sensitivity of demand. This is not true for decisions made by firms with market power. A change in the price sensitivity of demand rotates the demand curve, thereby rotating the firm’s marginal revenue curve. The firm’s profit-maximizing price-quantity combination is now at the intersection of the new marginal revenue curve and the marginal cost curve.

10. Name some regulations the government imposes on firms with market power.

    Governments use a variety of regulations to restrict market power and decrease deadweight loss, including:

    1. Direct price regulations that set the price that a firm may charge in a market.

    2. Antitrust laws that restrict firms from behaviors that limit competition in a market.