2.10–2.11 · Information and market power

IB Diploma Programme Economics HL, Unit 2 Microeconomics (first assessment 2022). This topic covers the two HL market failures: asymmetric information 信息不对称 (2.10) and market power 市场力量 (2.11). Market power needs the four market structures 市场结构, so you also learn perfect competition, monopoly, monopolistic competition and oligopoly here. All numbers are original, and each diagram is drawn from them.

In April 2021 China's market regulator fined Alibaba 18.2 billion yuan. The platform had told sellers they could not also sell on rival platforms. A firm can only give such orders when buyers and sellers have few other choices: that is market power. This topic explains where such power comes from, why it makes markets fail, and what governments can do about it.

Must-know for this topic:

Asymmetric information (2.10) means one side of a deal knows more than the other. The seller of a used car knows its faults. A person buying health insurance knows their own health. A borrower knows how likely they are to repay. When information is unequal, the market can fail. Some trades that would help both sides do not happen, and some trades that happen are bad ones.

Adverse selection

Adverse selection 逆向选择 happens BEFORE the contract. One side hides facts about itself or its product. Think of a used-car market where buyers cannot tell good cars from bad ones ("lemons"). Buyers will only pay an average price. Owners of good cars will not sell at that price, so they leave the market. Now the average car is worse, so buyers offer even less. In the end mostly bad cars are left. Insurance works the same way: at one average price, the riskiest people buy most and the safest people buy less.

Moral hazard

Moral hazard 道德风险 happens AFTER the contract. Once someone is protected, they take more risk, because someone else pays for the damage. An insured driver may drive less carefully. A bank that expects the government to rescue it may make riskier loans.

Responses to asymmetric information

• Screening 筛选: the side with less information collects it. Insurers ask for health checks; banks check credit scores.
• Signalling 信号传递: the side with more information proves its quality. Sellers offer a warranty 保修; workers show qualifications.
• Government regulation 政府监管: rules that force sellers to tell the truth (food labels, car inspection reports), licences for doctors and lawyers, and compulsory insurance so the low-risk people stay in.
• Contract design: an excess 免赔额 (the insured person pays the first part of any claim) and no-claims discounts keep some risk with the insured, which reduces moral hazard.

Each response has a limit. Screening costs money. A signal can be faked. Regulation needs inspectors who can be trusted.

The profit-maximising rule

Every firm in this topic is assumed to want the most profit. It compares the extra revenue and the extra cost of one more unit:

• Total revenue 总收益 (TR) $= P \times Q$.
• Average revenue 平均收益 (AR) $= TR / Q$, which is the price. So the AR curve is the firm's demand curve.
• Marginal revenue 边际收益 (MR) is the extra revenue from selling one more unit.
• Marginal cost 边际成本 (MC) is the extra cost of producing one more unit, and average total cost 平均总成本 (ATC) is total cost $/ Q$.

The rule for profit maximisation 利润最大化 is to produce where MR = MC. Below that output, one more unit adds more to revenue than to cost, so profit rises. Above it, one more unit adds more to cost, so profit falls.

Worked example. A firm faces the demand curve $P = 70 - Q/2$.

TR rises by 800 from 20 to 40 units, but only by 400 from 40 to 60 units. MR falls because the firm must lower the price on ALL its units to sell one more. For a straight-line demand curve, the MR line starts at the same point and is twice as steep: here MR $= 70 - Q$. MR is zero at $Q = 70$, where TR is largest.

Three kinds of profit

Economists count the owner's next-best use of their money and time as a cost. Normal profit 正常利润 is the least profit that keeps the owner in this business. It is already inside ATC. So:

• abnormal profit 超额利润: price above ATC ($P > ATC$);
• normal profit: price equal to ATC ($P = ATC$);
• loss 亏损: price below ATC ($P < ATC$).

Profit (or loss) per day $= (P - ATC) \times Q$.

Two kinds of efficiency

• Allocative efficiency 配置效率: $P = MC$. The value buyers put on the last unit equals the cost of making it, so society gets the right amount.
• Productive efficiency 生产效率: the firm produces at the lowest point of its ATC curve, so nothing is wasted in production.

Compare each market structure against these two tests.

Characteristics

Perfect competition 完全竞争 is a model with:

• very many small firms and buyers;
• homogeneous 同质的 (identical) products, such as one farmer's wheat and another's;
• no barriers to entry 进入壁垒, so firms can enter or leave freely;
• perfect information for everyone.

No single firm can change the market price. If it charged more, buyers would go to another firm. Each firm is a price-taker 价格接受者: the market's price is its demand curve, and also its AR and MR ($P = AR = MR$).

Short run and long run

Worked example. One firm's costs give MC $= 4 + 2q$ and ATC $= 100/q + 4 + q$.

1. Short run. The market price is 36. MR = MC: $36 = 4 + 2q$, so $q = 16$. ATC at 16 is $100/16 + 4 + 16 = 26.25$. Abnormal profit $= (36 - 26.25) \times 16 = 156$ per day.
2. Entry. There are no barriers, so new firms join. Market supply shifts right (S1 to S2) and the price falls.
3. Long run. Entry stops when profit is normal. That happens at the lowest ATC: $q = 10$, ATC $= 10 + 4 + 10 = 24$. At $P = 24$, MR = MC gives $24 = 4 + 2q$, so $q = 10$ and $P = ATC$.

It also works the other way. If the price is below ATC, firms make losses. Some leave the market, supply shifts left, and the price rises until the remaining firms earn normal profit.

In the long run, $P = MC$ (allocatively efficient) and output is at the lowest ATC (productively efficient). This is why perfect competition is the benchmark for judging the other structures. Real markets are rarely perfect, but some farm markets come close.

Characteristics and barriers to entry

A monopoly 垄断 is one firm supplying the whole market, with no close substitutes 替代品. In practice, a firm with a very large share can act like a monopoly (UK competition law uses a 25% share as one test). A monopolist is a price-maker 价格制定者: it faces the downward-sloping market demand curve, so it chooses a price and accepts the quantity buyers then want.

Its power lasts only while barriers to entry keep rivals out:

• economies of scale 规模经济: a big firm's low cost per unit means a small entrant cannot compete;
• legal barriers: patents 专利, licences and copyrights;
• control of an essential resource, such as a mine or a port;
• strong brands and heavy advertising;
• network effects 网络效应: a platform is more useful when everyone else already uses it, as with social media and online shopping sites.

The monopoly diagram

The monopolist uses the same rule as every firm. With demand (AR) $P = 70 - Q/2$, MR $= 70 - Q$ and MC $= 10 + Q/2$:

The firm charges the highest price buyers will pay for 40 units, read from the demand curve: $P_m = 70 - 40/2 = 50$. Its ATC is $900/Q + 10 + Q/4$, so at 40 units ATC $= 22.5 + 10 + 10 = 42.5$. Abnormal profit $= (50 - 42.5) \times 40 = 300$ per day. Barriers to entry stop new firms from competing it away, so the profit can last into the long run.

Notice that MR = MC happens where MC is 30, but the price is 50. A monopolist always sets the price above marginal cost.

Monopoly and efficiency

Compare the monopoly with a competitive market facing the same demand and cost. Under competition, output goes to where $P = MC$: $70 - Q/2 = 10 + Q/2$, so $Q = 60$ and $P = 40$.

• The monopolist produces 20 fewer units and charges 10 more.
• Consumers lose $(50 - 40) \times 40 = 400$ per day to the firm as a higher price.
• The units from 40 to 60 are not made, though buyers value them above their cost. This is the deadweight loss 无谓损失: $\tfrac12 \times (60 - 40) \times (50 - 30) = 200$ per day.

So a monopoly is allocatively inefficient ($P = 50 > MC = 30$). It is also productively inefficient: its ATC is lowest at 60 units (ATC = 40), but it produces only 40. Without competition, managers may also let costs rise above the lowest possible level. This is called X-inefficiency X非效率.

The case for large firms

Size can also help consumers:

• Economies of scale can make costs so low that even the monopoly price is below what small competing firms could charge.
• Abnormal profit can pay for research and development 研发 (R&D): new medicines, phones and software often come from large, profitable firms. This is dynamic efficiency 动态效率, improvement over time.
• A monopoly that is open to a world market may still face strong foreign competition.

An evaluation compares these gains with the deadweight loss, and asks whether the barriers protect real advantages or just protect profit.

Natural monopoly

A natural monopoly 自然垄断 is an industry where one firm can supply the whole market at a lower cost than two or more firms. The reason is a very large fixed cost: one water network, one electricity grid, one railway line. Average cost keeps falling across the whole market demand. Splitting the firm would raise costs, so governments regulate it instead.

Worked example. Demand is $P = 70 - Q/2$, MC is a constant 10, and the fixed cost is 1,000 per day, so AC $= 10 + 1000/Q$.

Marginal-cost pricing needs a subsidy 补贴 of 1,000 a day, or the firm closes. Average-cost pricing needs no subsidy and still raises output from 60 to 100. Many governments choose this, or own the firm themselves.

Monopolistic competition 垄断竞争 has many firms, low barriers to entry and product differentiation 产品差异化: each firm's product is a little different. Milk-tea shops, hair salons and restaurants are examples. Each firm has a few loyal customers, so it faces its own downward-sloping demand curve (d). But there are many close substitutes, so demand is quite elastic. Firms compete with non-price competition 非价格竞争: brands, advertising, location, service and new flavours.

Worked example. One shop has MC $= 4 + 2q$ and ATC $= 100/q + 4 + q$.

1. Short run. Demand is $P = 44 - q$, so MR $= 44 - 2q$. MR = MC gives $q = 10$ and $P = 34$. ATC is 24, so abnormal profit $= (34 - 24) \times 10 = 100$.
2. Long run. The profit attracts new shops nearby. Each shop loses customers, so its demand curve shifts left. Entry stops when demand just touches the ATC curve: here at $q = 8$, where $P = ATC = 24.5$ and profit is normal.

In the long run the firm is still inefficient. Its price (24.5) is above MC (20), so it is not allocatively efficient. It produces 8 units, not the 10 where ATC is lowest, so it is not productively efficient either. This gap is excess capacity 过剩产能: the shop could serve more customers at a lower cost per customer. In return, consumers get more variety.

Characteristics

An oligopoly 寡头垄断 is a market with a few large firms and high barriers to entry. Products may be the same (oil, steel) or differentiated (cars, phones, airlines). The key feature is interdependence 相互依存: each firm's best choice depends on what its rivals do. If one airline cuts its fares, the others lose passengers unless they cut too.

Game theory

Game theory 博弈论 studies choices that depend on what others choose. A payoff matrix shows each firm's profit for each pair of choices.

Read it from Airline A's side:

• If B sets a high fare, A earns 20 with a high fare or 28 with a low fare. Low is better.
• If B sets a low fare, A earns 8 with a high fare or 12 with a low fare. Low is better again.

So a low fare is A's dominant strategy 占优策略: its best choice whatever B does. The same is true for B. Both choose low and earn 12 each. Neither can gain by changing alone, so this is the Nash equilibrium 纳什均衡. But both would earn 20 if both kept fares high. This "prisoner's dilemma" explains both sides of oligopoly: the reward for working together, and the temptation for each firm to cheat.

Collusion and competition

• Collusion 共谋: firms agree to limit output or fix prices, moving towards the monopoly outcome. A formal agreement is a cartel 卡特尔. OPEC, a group of oil-exporting countries, sets output targets for its members. Cartels between firms are illegal in most countries, including China.
• Tacit collusion 默契共谋: no agreement is made, but firms follow each other. One firm acts as price leader 价格领导者 and the others copy its prices.
• Non-collusive oligopoly: firms compete. A price war 价格战 can push prices close to cost. Because price cuts are quickly copied, most oligopolies prefer non-price competition: advertising, brands and new models.

Cartels tend to break down. Each member can gain by secretly producing more than its quota, exactly as in the game above.

Measuring concentration

A concentration ratio 集中度 adds the market shares of the largest firms. If the five largest firms have shares of 40%, 25%, 15%, 10% and 10%, the four-firm ratio is CR4 $= 40 + 25 + 15 + 10 = 90\%$: a highly concentrated market. The ratio has limits. It ignores foreign rivals and imports. It does not show whether the largest firm has 40% or 85% of a CR4 of 90. And it says nothing about how firms actually behave.

Market power is a market failure because output is too low and the price too high ($P > MC$). Governments respond in several ways:

• Competition law 竞争法: bans cartels and the abuse of a dominant position, and can block mergers 并购 that would create too much power. In 2017 the European Commission fined Google 2.42 billion euros for favouring its own shopping service in search results.
• Regulation: price caps and quality targets for natural monopolies such as water and electricity.
• Fines that are large enough to make breaking the law unprofitable.
• Government ownership 国有化 (nationalisation) of natural monopolies.
• Trade liberalisation 贸易自由化: removing tariffs lets foreign firms compete with a domestic monopoly.

Each response has costs. Regulators may lack information about the firm's true costs (asymmetric information again). Breaking up a firm may lose economies of scale. State-owned firms may suffer from X-inefficiency. A good answer weighs the efficiency gain against these costs.

• Asymmetric information: adverse selection before the contract (the used-car "lemons" market, insurance) and moral hazard after it; screening, signalling, regulation and contract design as responses, each with a limit (2.10).
• TR, AR and MR from a demand curve; for a straight-line demand curve MR is twice as steep; the MR = MC rule and why it maximises profit.
• Abnormal profit, normal profit and losses from $P$ against ATC; allocative efficiency ($P = MC$) and productive efficiency (lowest ATC).
• Perfect competition: characteristics, price-taker with $P = AR = MR$; short-run profit of 156 at $P = 36$; entry until $P = 24 =$ lowest ATC; efficient in the long run.
• Monopoly: barriers to entry; $Q_m = 40$, $P_m = 50$, ATC 42.5, profit 300; against competition at (60, 40), consumers lose 400 and the deadweight loss is 200; allocatively and productively inefficient, X-inefficiency; economies of scale and R&D as the case for size.
• Natural monopoly: AC still falling across market demand; unregulated (60, 40), $P = MC$ at (120, 10) with a loss of 1,000, $P = AC$ at (100, 20).
• Monopolistic competition: differentiation and non-price competition; short-run profit of 100; long run $P = ATC = 24.5$ at $q = 8$, above MC of 20, with excess capacity.
• Oligopoly: interdependence; the payoff matrix, dominant strategy and Nash equilibrium (12, 12) against collusion (20, 20); cartels, tacit collusion and price leadership, price wars and non-price competition; CR4 = 90% and its limits.
• Government responses: competition law and merger control, regulation, fines, nationalisation and trade liberalisation, and their costs.