Market Dynamics: Firm Demand and Monopoly Power

Market Dynamics: Competition and Demand

Pure monopoly is a rare case. More frequently, several companies compete in markets. Suppose, for example, that four companies producing toothbrushes face the market demand curve shown in a graph. These companies produce a total of 20,000 toothbrushes daily, selling each for $1.50.

At this price, the market demand is inelastic, with an elasticity of -1.5.

Market vs. Firm Demand Curves

The graph (A) shows the market demand for toothbrushes. Graph (B) shows the demand for toothbrushes as seen by Company A. While the market demand elasticity at $1.50 is -1.5, Company A faces a much more elastic demand curve (Da) due to competition from other businesses. At a price of $1.50, Company A's demand elasticity is -6.

Understanding Firm-Specific Demand

Even so, Company A retains some monopoly power. Its profit-maximizing price is $1.50, which exceeds its marginal cost. If Company A considers lowering its price to increase sales, it needs to understand how its sales respond to price changes. In other words, it needs to know the demand curve it faces. The graph illustrates why the company's demand curve (Da) is much more elastic than the overall market demand curve.

The company could predict that if the price rises from $1.50 to $1.60, its sales would decrease from 5,000 to 3,000 units, and more consumers would buy toothbrushes from other companies. However, sales would not drop to zero, as would occur in a perfectly competitive market, for two main reasons:

• First, if Company A's toothbrushes are somewhat differentiated from its competitors', some consumers might be willing to pay a little more for them.
• Secondly, other companies might also raise their prices.

Therefore, the company's demand depends heavily on how much its product is differentiated from its competitors'. Although the four companies compete among themselves, Company A likely faces a more elastic demand curve than the market demand curve, but not a perfectly elastic curve like a company in perfect competition.

Measuring Monopoly Power: The Lerner Index

In a competitive company, price equals marginal cost. Therefore, to measure the degree to which the profit-maximizing price exceeds the marginal cost, we can use the price-cost margin rule introduced earlier for pricing practices. This measurement is called the Lerner Index of Monopoly Power, which is the difference between price and marginal cost, divided by the price. It always has a value between zero and one.