We are now aware how profit-maximizing firms with market power should make production and pricing decisions. We can use this behavior to think through the effects of various market changes, much as we did with supply and demand in the competitive setting. Even though firms with market power do not have a supply curve, we will see that in some ways they react similarly to competitive firms. There are some ways they can react, however, that are quite different.

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Let’s first think about the effect of an increase in marginal cost. In the iPad example, marginal cost was constant at $200 and the inverse demand curve was P = 1,000 – 5Q (where Q is in millions). Suppose there’s a fire in the plant that manufactures the screen on the iPad, raising the marginal cost of screens, and as a result, the marginal cost of the iPad increases from $200 to $250. What will happen in the market for iPads?

To determine the market impact of this increase in marginal cost, we follow the three-step method but with the new marginal cost curve:

Step 1: Derive the marginal revenue curve. The demand curve hasn’t changed, so this is the same as before: MR = 1,000 – 10Q.

Step 2: Find the quantity at which MR = MC. The MC is now $250, so

1,000 – 10Q = 250

750 = 10Q

Q^* = 75

The new profit-maximizing quantity is 75 million units, down from 80 million.

Step 3: Determine the profit-maximizing price using the optimal quantity and the demand curve. The (inverse) demand curve is P = 1,000 – 5Q. Plugging in the new quantity, we have P^* = 1,000 – 5(75) = $625. The new price will be $625, up from $600 before the fire.

We illustrate the change from the initial equilibrium to the new one in Figure 9.4. The initial quantity of 80 million is set by MR = MC₁ ($200) at point a. This quantity corresponds to a price of $600, as indicated at point b. After the fire, the marginal cost curve shifts up to $250 (MC₂). Because the fire only affects the supply side of the market, the consumer’s willingness to pay does not change, and the demand and marginal revenue curves do not shift. Now marginal revenue equals marginal cost at point c, at a quantity of 75 million. Following that quantity up to the demand curve (at point d), we can see that the price of an iPad will rise to $625.

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A firm with market power responds to a cost shock in a way that is similar to a competitive firm’s response. When marginal cost rises, price rises, and output falls. When marginal cost falls, price falls, and output rises.

But in competition, a change in marginal cost is fully reflected in the market price, because P = MC. That doesn’t have to be the case when the seller has market power. In the iPad example, the market price rose only $25 in response to a $50 increase in marginal cost. To maximize its profit, Apple does not want to pass along the full increase in its cost to its customers. The drop in quantity that results from the increase in cost is also smaller than the drop that would occur in a perfectly competitive market. Note, however, that the equilibrium quantity is still higher in a competitive market than one with market power, even after the cost increase. It’s the change in Q that is smaller.6

Now suppose that instead of a cost shift, there is a parallel shift in the demand curve. Perhaps a revision of the iPad’s OS doubles battery life, increasing demand and shifting out the demand curve. Specifically, let’s say the new inverse demand curve is P = 1,400 – 5Q. How would the market react to this change?

Again, we follow the three-step method. Because the demand curve has shifted in this case, the marginal revenue curve changes as well. The new demand curve is linear, so we know how to derive the marginal revenue curve; we double the number in front of the quantity in the inverse demand curve. So,

MR = 1,400 – 10Q

Setting this equal to the marginal cost (which we’ll assume is back at its original level of $200) implies

1,400 – 10Q = 200

10Q = 1,200

Q^* = 120

The quantity produced after the demand shift is now 120 million units, up from 80 million. Finally, we find the new price by plugging this quantity into the inverse demand curve:

P^* = 1,400 – 5Q^*

= 1,400 – 5(120)

= 800

The new price is $800, up from $600 before the demand shift.

An outward demand shift leads to an increase in both quantity and price in a market where the seller has market power, the same direction as in perfect competition. But again, the size of the changes differs.

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One type of market change to which firms with market power react very differently from competitive firms is a change in the price sensitivity of demand—in other words, making the demand curve steeper or flatter. Say a new competing tablet comes along so that consumers’ demand for iPads becomes more price-sensitive but doesn’t change the quantity demanded at the current price. With perfect competition, as in panel a of Figure 9.5, the flattening of the demand curve does not change the point at which P = MC (as embodied in the supply curve), so neither price nor quantity moves. The price sensitivity of consumers does not impact the sellers’ output decisions as long as price is still equal to marginal cost.

Things are different, though, if the same demand curve rotation happens in a market in which there is a seller with market power. That’s because with market power, the rotation in demand also moves the marginal revenue curve as shown in panel b of Figure 9.5. Even though the new demand curve D₂ crosses the marginal cost curve at the same quantity as the old demand curve, MR₂ intersects the marginal cost curve at a higher quantity than did MR₁ ( Q^*_m2 instead of Q^*_m1). Therefore, the firm’s output rises as a result of the demand curve rotation and the price falls.

The opposite pattern holds when consumers become less price-sensitive and firms have market power: Output falls and price rises. Again, these changes wouldn’t happen in perfect competition because suppliers’ choices don’t depend on the price sensitivity of demand.

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