Question

In the market A the price a company charges per product is $ 20 and its marginal cost is $ 10. In market B, another company sells a product at $ 30 and its marginal cost is $ 20. i) Who has greater market power company A or company B? ii) If we now know that the elasticity of demand is -2 in the market A and -0.3 in the market B. Who has greater market power? Why?

Answer 1

Market power is the capacity of the firm/producer to charge a price higher than its marginal cost.

An appropriate index of market power is L=(P-MC)/P. A higher value of L indicates higher market power.

1) In the market A the price a company charges per product is $ 20 and its marginal cost is $ 10. In market B, another company sells a product at $ 30 and its marginal cost is $ 20.

So market power for company A is L=(20-10)/20=0.5

market power for company B is L=(30-20)/30=0.33

Thus company A has higher market power.

2) The relation between price markup (P/MC) and elasticty of demand e is : P/MC=1/(1+1/e). A higher price markup indicates higher market power.

So when elasticity is -2, then price markup P/MC=1/(1-1/2)=2

When elasticity is -0.3, then Price Markup P/MC=1/(1-1/0.3). But here price markup comes out to be negative which is not possible. This anamoly arises because the demand is inelastic, and in a market with inelastic demand the firm cannot have market power because it will not cater to inelastic demand.

Thus market A which has elasticity of -2 has a higher market power.