Summary

  1. Most firms have some market power, meaning that the firm’s production decisions affect the market price of the good it sells. Firms maintain market power through barriers to entry into the market. These barriers include natural monopolies, switching costs, product differentiation, and absolute cost advantages of key inputs. [Section 9.1]

  2. A monopoly is the sole supplier of a good in a market and represents the extreme case of a firm with complete market power. Monopolies and other firms with market power base their production decisions, in part, on their marginal revenue, the revenue from selling an additional unit of a good. Unlike perfectly competitive firms, these firms’ marginal revenue falls as output rises. As a result, when a firm increases its production of a good, its marginal revenue falls, because it must sell all units of the good (not just the additional unit) at a lower price. [Section 9.2]

  3. The profit-maximizing output level for a monopolist is found where marginal revenue equals marginal cost, MR = MC. A monopoly will charge a price above its marginal cost, meaning that the market price for a monopoly is higher than that for a perfectly competitive firm. The Lerner index computes how much a firm should mark up its price; the more inelastic the demand for a product, the higher the firm’s Lerner index and markup. [Section 9.3]

  4. The changes in quantity supplied and price created by cost and demand shocks have the same direction, but different magnitudes, for firms with market power as for perfectly competitive firms. However, firms with market power respond differently to changes in consumers’ price sensitivities—that is, rotations in the demand curve—than do perfectly competitive firms. [Section 9.4]

  5. When a firm exercises its market power, it increases its producer surplus, decreases consumer surplus, and creates a deadweight loss. Producer surplus is greater when consumers are relatively price-insensitive and the demand curve is steep. [Section 9.5]

  6. Governments often intervene to reduce the deadweight loss created by firms with market power. Direct price regulation and antitrust laws are aimed at reducing firms’ market power. Conversely, governments also grant market power to firms through patents, copyrights, and other laws as a way of promoting innovation. [Section 9.6]