Lecture on Market Power and Price Elasticity of Demand

Market Power and Pricing

• Producers with market power choose not to produce where demand equals marginal cost.
• Instead, they restrict production to where marginal revenue equals marginal cost.
• They mark up the price based on the marginal consumer's willingness to pay.

Impact of Demand Elasticity

• Elastic Demand: Flatter demand curve, lower markup, and reduced deadweight loss.
• Price Elasticity of Demand:
  • Formula: Percent change in quantity demanded / Percent change in price.
  • Absolute value determines elasticity type:
    • Elastic: Absolute value > 1
    • Unit Elastic: Absolute value = 1
    • Inelastic: Absolute value < 1
  • Always negative due to the law of demand, hence use of absolute value.

Factors Affecting Demand Elasticity

• Availability of Substitutes: More substitutes lead to higher elasticity.
• Time to Adjust: More time allows exploration of alternatives, increasing elasticity.
• Specificity of Product: More specific = more sensitive to price (luxuries vs. necessities).
• Budget Impact: Larger expense percentage leads to higher price sensitivity.

Monopoly Markup

• Profit Maximizing Price: Dependent on price elasticity of demand.
• As elasticity increases, price approaches marginal cost, reducing monopoly markup.
• Example Calculations:
  • Elasticity = -2: Markup results in a price of $10 with a marginal cost of $5.
  • Elasticity = -3: Price reduces to $7.50, markup decreases.
  • Elasticity = -6: Price lowers to $6, reducing markup further.

Strategies for Firms with Market Power

• Price Discrimination: Charging different prices based on consumer sensitivity.
  • Second Degree Price Discrimination: Bulk pricing based on quantity purchased.
    • Example: "Buy one, get one free".
    • Suitable when demand correlates with quantity desired.
  • Third Degree Price Discrimination: Different prices for different groups.
    • Example: Discounts for seniors, students.
    • Requires identifiable group differences and prevention of arbitrage.

Case Study: Roman Haas and PMMA

• Product: Poly methyl methacrylate (PMMA) used in dentistry and industry.
• Market Segmentation:
  • Inelastic demand in dentistry (few alternatives), elastic in industry.
  • Price for dentists: $22/pound, industry: $0.85/pound.
• Arbitrage Challenges: Potential for profit from buying industrial PMMA and selling to dentists.
• Solution: Rumor of arsenic in industrial PMMA to prevent misuse.

These notes capture the key elements of the lecture, focusing on understanding market power, elasticity, and the strategic use of pricing to maximize profits.