Lesson 3: Competition and Market Power

 

Competition and Market Power

Key Terms

• Competitive markets
• Market Power
• Price discrimination

National Content Standards Addressed:

Standard 7 - Markets exist when buyers and sellers interact. This interaction determines market prices and thereby allocates scarce goods and services.

Standard 8 - Prices send signals and provide incentives to buyers and sellers. When supply or demand changes, market prices adjust, affecting incentives.

Lesson Objectives (5)

1. Competition regulates markets:
   • by making sellers responsive to the wishes of buyers;
   • by rewarding the most efficient, or least-cost, sellers with returns equal to or above their opportunity costs; and
   • by encouraging the flow of resources to their most highly-valued uses.

2. In competitive markets, price increases caused by changes in either supply or demand are the result of increases in marginal costs; prices and marginal costs are directly related.
   • The higher prices which accompany increased demand indicate buyers' willingness to bear higher opportunity costs in order to purchase particular goods and services.
   • The higher prices which accompany decreased supply indicate the higher opportunity costs producers must bear (because of higher prices for resources or the existence of other, more profitable, production alternatives) in order to provide particular goods and services.

3. The term "market power" refers to the influence that any particular buyer or seller can exercise over the price of a product. Market structures range from highly competitive, in which there are so many buyers or sellers that none can influence the market price, to the other extreme in which a single buyer or seller faces no competition and therefore wields great market power.
   • In markets characterized by free entry, attempts by sellers of products or resources to raise prices in the absence of cost increases are generally unsuccessful.
   • Similarly, in markets characterized by free entry, attempts by buyers of products or resources to lower prices in the absence of cost decreases are generally unsuccessful.

4. The persistence of large differences between price and production cost usually indicates that entry is restricted.
   • This may be the result of limited availability of specialized resources or of government restriction to entry.
   • Government intervention in response to a special interest group often results in reduced competition and the creation of market power for that group.
   • Because the costs imposed on consumers by the government response to any particular lobbying effort are diffuse and individually small, consumers generally do not organize to oppose the influence of the special interest groups. The benefits to the special interest groups are large enough to give them an incentive to organize and lobby.

5. Price discrimination, charging different people different prices for the same good, is possible because individuals place different subjective values on goods.
   • Price discrimination is most likely to occur when the seller can identify groups of buyers who place different relative values on a good or service and when resale of the item among customers is either impossible or highly unlikely.
   • Pricing of airline and movie theater tickets are good examples of price discrimination.

Teaching and Discussion Ideas

Run an additional round of the market teaching activity which the mentor teacher demonstrated just prior to this lecture. However, this time, use a disproportionate number of buyers and sellers.

• Run the activity with students only, identifying two students as sellers and the rest of the students as buyers.
• Position the two sellers a few chairs apart and give them each half of the seller cards from the previous activity. Instruct the sellers that they can make as many transactions as they wish in each round, but they must draw a new card from their stack of seller cards for each transaction.
• Distribute the buyer cards, one each, to the rest of the students.
• Instruct the buyers that they may make transactions as in the last round of the previous activity.
• Record all transactions. (The number of transactions will be slightly less and the average price will be slightly higher than in the previously played rounds.)
• Debrief:
  • Was there competition between the sellers?
  • Who seemed to have more market power - the buyers or the sellers?
  • Which type of market did you prefer, as a buyer? as a seller?
• (corresponds to lecture objectives #3 and #4)

Sample Interactive Discussion Problems:

Pose a problem requiring students to isolate and identify the characteristics of a market which makes price discrimination possible.

1. Why do movie theaters charge different people different prices for tickets, but charge everyone the same price for popcorn?

Sample Small Group Discussion Problems:

Pose a problem requiring students to design a system of price discrimination.

2. Design a system of price discrimination for highway use in a large city based on what you know about traffic usage during a typical week.

Pose a problem in which students consider the incentive structure inherent in a cartel.

3. Suppose that five major oil-producing nations of the world get together and, with the goal of increasing revenue and profit, agree to cooperate in such a way as to act as if they were a single supplier.
   • What actions could they take to achieve their goal?
   • Consider each action on the list individually. What is the likely impact on the price of oil? Why?
   • What is the likely result in terms of the revenues of oil producers?
   • Consider each action on the list individually. Are the benefits and costs of each action the same for all producers?
   • What is the incentive for individual producers to abide by any agreement?
   • What is the incentive for individual producers to cheat on any. agreement?
   • What would be necessary in order to maintain (enforce) the agreements?
   • What do you predict will happen in the long run?

Definitions

Competitive markets - Markets characterized by relative ease of entry and exit and by large numbers of sellers who provide products which consumers regard as substitutes for one another.

Market power - The degree to which a business firm is able to earn larger than normal profits, market power is inversely related to both the degree of competition in the market and the ease of entry and exit.

Price discrimination - The practice of charging different groups of consumers different prices for the same good or service.

 

Copyright © 1999 Foundation for Teaching Economics
Permission granted to copy for classroom use.