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Market Power Lecture 7
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Social Welfare |
1. Consumers' surplus – consumers willingness to pay for a product or service
Willingness to pay (WTP) is measured in dollars
Some consumers are willing to pay more
An aggregate benefit to all consumers in the market

Example: One consumer is willing to pay $2.50, but he does not have to. He pays $1.50
If the market price increases, then consumers' surplus falls


2. Producers' surplus – an aggregate benefit to all producers in a market

Note – Qm is minimum supply
Producers' surplus – profits plus total fixed costs
Example – One producer could produce item for $8; however, he gets $10 per unit
If market price increases, then producers' surplus increases


3. Social Welfare / Total Surplus = producers' surplus + consumers' surplus

Competitive markets give the highest social welfare
All other market structures have lower social welfare
Note – skip Pareto Optimality
Two types of demand functions
Marshallian demand function – standard demand function
Law of Demand – a lower market price causes higher market quantity
Income effect – a lower price increases consumers' real income (i.e. higher utility)
Substitution effect – changes consumers' buying behavior
Hicksian demand function – theoretical
If the income effect is small, then social welfare from a Marshallian demand function is similar to a Hicksian
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How Market Power can influence the Market Price |
1. Characteristics
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Supply side substitution – if firm raises prices, consumers switch to another firm
Demand side substitution – if firm raises prices, consumers switch to another product
Market: Breakfast cereals appear to be a concentrated industry
However, if firms raise prices, then consumers switch to other breakfast cereals
Monopoly – price maker



Using,

Approximation,



Assume demand is linear, P(Q) = A – bQ


Competitive solution
Quantity
P = MC
P(Q) = A – bQ and MC(Q) = c
A –bQ = c, where Qc = (A – c)/b
Competitive market has twice the production
Price
Profits
P = TR – TC = P(Q)Q – cQ – FC = cQ – cQ – FC = -FC
Fixed costs have to be zero for a competitive industry
Fixed cost create a market barrier
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Deadweight Loss |
1. Deadweight Loss (DWL) of a monopoly
Monopoly causes a higher price and lower quantity
Demand function is linear; thus, DWL is an area of a triangle

2. An example
The milk industry has an inverse demand function, P(Q) = 100 – Q and a total cost function, T(q) = 30q
The industry has a monopoly
- Graph is below:

The average cost (AC) and marginal cost (MC) functions are:
Find Pm and Qm
Efficient level of milk production
Pc = MC and MC(Q) = 30
Thus, Pc = 30
Pc = 100 – Qc
Qc = 100 – 30 = 70
Consumers' surplus (CS) under a competitive market
Consumers' surplus under a monopoly market
Profits under a competitive market
Profits under a monopoly
Deadweight Loss (DWL)
Refer to the table
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Competitive
Market |
Monopoly |
Consumer Surplus |
2,450.00 |
612.50 |
Profits |
0.00 |
1,225.00 |
Total Social Welfare |
2,450.00 |
1,837.50 |
Deadweight Loss |
0.00 |
612.50 |
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The Lerner Index |
Lerner Index – measure of market power








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