Monopoly Power

Pure monopoly is rare. Markets in which several firms compete with one another are much more common. We say more about the forms that this competition can take in Chapters 12 and 13. But we should explain here why each firm in a market with several firms is likely to face a downward-sloping demand curve and, as a result, to produce so that price exceeds marginal cost.

Suppose, for example, that four firms produce toothbrushes and have the market demand curve Q = 50,000 − 20,000P, as shown in Figure 10.7(a). Let’s assume that these four firms are producing an aggregate of 20,000 toothbrushes per day (5000 each per day) and selling them at $1.50 each. Note that market demand is relatively inelastic; you can verify that at this $1.50 price, the elastic- ity of demand is −1.5.

Now suppose that Firm A is deciding whether to lower its price to increase sales. To make this decision, it needs to know how its sales would respond to a change in its price. In other words, it needs some idea of the demand curve it faces, as opposed to the market demand curve. A reasonable possibility is shown in Figure 10.7(b), where the firm’s demand curve DA is much more elastic than the market demand curve. (At the $1.50 price the elasticity is −6.0.) The firm might predict that by raising the price from $1.50 to $1.60, its sales will drop—say, from 5000 units to 3000—as consumers buy more toothbrushes from other firms. (If all firms raised their prices to $1.60, sales for Firm A would fall only to 4500.) For several reasons, sales won’t drop to zero as they would in a perfectly competitive market. First, if Firm A’s toothbrushes are a little different from those of its com-petitors, some consumers will pay a bit more for them. Second, other firms might also raise their prices. Similarly, Firm A might anticipate that by lowering its price from $1.50 to $1.40, it can sell more toothbrushes—perhaps 7000 instead of 5000. But it will not capture the entire market: Some consumers might still prefer the competitors’ toothbrushes, and competitors might also lower their prices.

Thus, Firm A’s demand curve depends both on how much its product differs from its competitors’ products and on how the four firms compete with one another. We will discuss product differentiation and interfirm competition in Chapters 12 and 13. But one important point should be clear: Firm A is likely to face a demand curve which is more elastic than the market demand curve, but which is not infinitely elastic like the demand curve facing a perfectly competitive firm.

Source: Pindyck Robert, Rubinfeld Daniel (2012), Microeconomics, Pearson, 8th edition.