Market power

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In economics, market power refers to the ability of a firm to influence the price at which it sells a product or service to increase economic profit. [1] In other words, market power occurs if a firm does not face a perfectly elastic demand curve and can set its price (P) above marginal cost (MC) without losing sales. [2] This indicates that the magnitude of market power is associated with the gap between P and MC at a firm's profit maximising level of output. Such propensities contradict perfectly competitive markets, where market participants have no market power, P = MC and firms earn zero economic profit. [3] Market participants in perfectly competitive markets are consequently referred to as 'price takers', whereas market participants that exhibit market power are referred to as 'price makers' or 'price setters'.

Contents

A firm with market power has the ability to individually affect either the total quantity or price in the market. This said, market power has been seen to exert more upward pressure on prices due to effects relating to Nash equilibria and profitable deviations that can be made by raising prices. [4] Price makers face a downward-sloping demand curve and as a result, price increases lead to a lower quantity demanded. The decrease in supply creates an economic deadweight loss (DWL) and a decline in consumer surplus. [5] This is viewed as socially undesirable and has implications for welfare and resource allocation as larger firms with high markups negatively effect labour markets by providing lower wages. [5] Perfectly competitive markets do not exhibit such issues as firms set prices that reflect costs, which is to the benefit of the customer. As a result, many countries have antitrust or other legislation intended to limit the ability of firms to accrue market power. Such legislation often regulates mergers and sometimes introduces a judicial power to compel divestiture.

Market power provides firms with the ability to engage in unilateral anti-competitive behavior. [6] As a result, legislation recognises that firms with market power can, in some circumstances, damage the competitive process. In particular, firms with market power are accused of limit pricing, predatory pricing, holding excess capacity and strategic bundling. [7] A firm usually has market power by having a high market share although this alone is not sufficient to establish the possession of significant market power. This is because highly concentrated markets may be contestable if there are no barriers to entry or exit. Invariably, this limits the incumbent firm's ability to raise its price above competitive levels.

If no individual participant in the market has significant market power, anti-competitive conduct can only take place through collusion, or the exercise of a group of participants' collective market power. [4] An example of which was seen in 2007, when British Airways was found to have colluded with Virgin Atlantic between 2004 and 2006, increasing their surcharges per ticket from £5 to £60. [8]

Regulators are able to assess the level of market power and dominance a firm has and measure competition through the use of several tools and indicators. Although market power is extremely difficult to measure, through the use of widely used analytical techniques such as concentration ratios, the Herfindahl-Hirschman index and the Lerner index, regulators are able to oversee and attempt to restore market competitiveness. [9]

Market Structure

Different Types of Market Structures Market Structures .jpg
Different Types of Market Structures

In economics, market structure depicts how different industries are characterized and differentiated based upon the types of goods the firms sell (homogenous/heterogenous) and the nature of competition within the industry. [10] The degree of market power firms assert in different markets are relative to the market structure that the firms operate in. There are four main forms of market structures that are observed: perfect competition, monopolistic competition, oligopoly, and monopoly. [10]

Perfect competition power

The concept of perfect competition represents a theoretical market structure where the market reaches an equilibrium that is Pareto optimal. This occurs when the quantity supplied by sellers in the market equals the quantity demanded by buyers in the market at the current price. [11] Firms competing in a perfectly competitive market faces a market price that is equal to their marginal cost, therefore, no economic profits are present. The following criteria need to be satisfied in a perfectly competitive market:

  1. Producers sell homogenous goods
  2. All firms are price takers
  3. Perfect information
  4. No barriers to enter and exit
  5. All firms have relatively small market share and cannot influence price

As all firms in the market are price takers, they essentially hold zero market power. A perfectly competitive market is logically impossible to achieve in a real world scenario as it embodies contradiction in itself and therefore is considered an idealised framework by economists. [12]

Monopolistic competition power

Monopolistic competition can be described as the "middle ground" between perfect competition and a monopoly as it shares elements present in both market structures that are on different ends of the market structure spectrum. [13] Monopolistic competition is a type of market structure defined by many producers that are competing against each other by selling similar goods which are differentiated, thus are not perfect substitutes. [14] In the short term, firms are able to obtain economic profits as a result of differentiated goods providing sellers with some degree of market power; however, profits approaches zero as more competitive toughness increases in the industry. [15] The main characteristics of monopolistic competition include:

  1. Differentiated products
  2. Many sellers and buyers
  3. Free entry and exit

Firms within this market structure are not price takers and compete based on product price, quality and through marketing efforts. [16] Examples of industries with monopolistic competition include restaurants, hairdressers and clothing.

Monopoly power

The word monopoly is used in various instances referring to a single seller of a product, a producer with an overwhelming level of market share, or refer to a large firm. [17] All of these treatments have one unifying factor which is the ability to influence the market price by altering the supply of the good or service through its own production decisions. The most discussed form of market power is that of a monopoly, but other forms such as monopsony and more moderate versions of these extremes exist. A monopoly is considered a 'market failure' and consists of one firm that produces a unique product or service without close substitutes. Whilst pure monopolies are rare, monopoly power is far more common and can be seen in many industries even with more than one supplier in the market. [18] Firms with monopoly power can charge a higher price for products (higher markup) as demand is relatively inelastic. [19] They also see a falling rate of labour share as firms divest from expensive inputs such as labour. [20] Often, firms with monopoly power exist in industries with high barriers to entry, which include, but are not limited to:

  1. Economies of scale
  2. Predatory pricing [18]
  3. Control of key resources (required in production of the good)
  4. Legal regulations [19]

A well-known example of monopolistic market power is Microsoft's market share in PC operating systems. The United States v. Microsoft case dealt with an allegation that Microsoft illegally exercised its market power by bundling its web browser with its operating system. In this respect, the notion of dominance and dominant position in EU Antitrust Law is a strictly related aspect. [21]

Oligopoly power

Another form of market power is that of an oligopoly or oligopsony. Within this market structure, the market is highly concentrated and several firms control a significant share of market sales. [22] The main characteristics of an oligopoly are:

  1. A few sellers and many buyers.
  2. Homogenous or differentiated products.
  3. Barriers to entry. This includes, but is not limited to, 'technology challenges, government regulations, patents, start-up costs, or education and licensing requirements'. [23]
  4. Interaction/strategic behaviour.

It is salient to note that only a few firms make up the market share. Hence, their market power is large as a collective and each firm has little or no market power independently. [24] Generally, when a firm operating in an oligopolistic market adjusts prices, other firms in the industry will be directly impacted.

The graph below depicts the kinked demand curve hypothesis which was proposed by Paul Sweezy who was an American economist. [25] It is important to note that this graph is a simplistic example of a kinked demand curve.

Kinked Demand Curve KinkedDemandCurve.gif
Kinked Demand Curve

Oligopolistic firms are believed to operate within the confines of the kinked demand function. This means that when firms set prices above the prevailing price level (P*), prices are relatively elastic because individuals are likely to switch to a competitor's product as a substitute. Prices below P* are believed to be relatively inelastic as competitive firms are likely to mimic the change in prices, meaning less gains are experienced by the firm. [26]

An oligopoly may engage in collusion, either tacit or overt to exercise market power. A group of firms that explicitly agree to affect market price or output is called a cartel, with the organization of petroleum-exporting countries (OPEC) being one of the most well known example of an international cartel.

Sources of market power

By remaining consistent with the strict definition of market power as any firm with a positive Lerner index, the sources of market power is derived from distinctiveness of the good and or seller. [27] For a monopolist, distinctiveness is a necessary condition that needs to be satisfied but this is just the starting point. Without barriers to entries, above normal profits experienced by monopolists would not persist as other sellers of homogenous or similar goods would continue to enter the industry until above normal profits are diminished until the industry experiences perfect competition [27]

There are several sources of market power including:

  1. High barriers to entry. These barriers include the control of scarce resources, increasing returns to scale, technological superiority and government created barriers to entry. [28] OPEC is an example of an organization that has market power due to control over scarce resources — oil.
  2. Increasing returns to scale. Firms that experience increasing returns to scale also experience decreasing average total costs and therefore become more profitable with size. [28]
  3. High start-up costs. This barrier makes it difficult for new entrants to succeed. Firms like power, cable television and telecommunication companies fall within this category. A firm seeking to enter such industries require the ability to spend millions of dollars before starting operations and generating revenue.
  4. Brand loyalty of consumers and value placed by consumers on reputation. Incumbent firms often have a competitive advantage over new entrants. An incumbent firm can engage in several entry-deterring strategies such as limit pricing, predatory pricing and strategic bundling. Microsoft has substantial pricing or market power due to technological superiority in its design and production processes. [28]
  5. Government policies/regulations. A prime example are patents granted to pharmaceutical companies. These patents give the drug companies a virtual monopoly in the protected product for the term of the patent.

Measurement of market power

Measuring market power is inherently complex because the most widely used measures are sensitive to the definition of a market.

Magnitude of a firm's market power is shown by a firm's ability to deviate from an elastic demand curve and charge a higher price (P) above its marginal cost (C), commonly referred to as a firm's mark-up or margin. [29] The higher a firm's mark-up, the larger the magnitude of power. This said, markups are complicated to measure as they are reliant on a firm's marginal costs and as a result, concentration ratios are the more common measures as they require only publicly accessible revenue data.

Concentration ratios

Market concentration, also referred to as industry concentration, refers to the extent of which market shares of the largest firms in the market account for a significant portion of the economic activities quantifiable by various metrics such as sales, employment, active users. [30] Recent macroeconomic market power literature indicates that concentration rations are the most frequently used measure of market power. [2] Measures of concentration summarise the share of market or industry activity accounted for by large firms. An advantage of using concentration as an empirical tool to quantify market power is the requirement of only needing revenue data of firms which results in the corresponding disadvantage of the inconsideration of costs or profits. [29]

N-firm concentration ratio

The N-firm concentration ratio gives the combined market share of the largest N firms in the market. For example, a 4-firm concentration ratio measures the total market share of the four largest firms in an industry. In order to calculate the N-firm concentration ratio, one usually uses sales revenue to calculate market share, however, concentration ratios based on other measures such as production capacity may also be used. For a monopoly, the 4-firm concentration ratio is 100 per cent whilst for perfect competition, the ratio is zero. [31] Moreover, studies indicate that a concentration ratio of between 40 and 70 percent suggests that the firm operates as an oligopoly. [32] These figures are viable but should be used as a 'rule of thumb' as it is important to consider other market factors when analysing concentration ratios.

An advantage of concentration ratios as an empirical tool for studying market power is that it requires only data on revenues and is thus easy to compute. The corresponding disadvantage is that concentration is about relative revenue and includes no information about costs or profits.

Herfindahl-Hirschman index

The Herfindahl-Hirschman index (HHI) is another measure of concentration and is the sum of the squared market shares of all firms in a market. [33] For example, in a market with two firms, each with 50% market share, the HHI equals = 0.502 + 0.502 = 0.50. The HHI for a monopoly is 1 whilst for perfect competition, the HHI is zero. Unlike the N-firm concentration ratio, large firms are given more weight in the HHI and as a result, the HHI conveys more information. However the HHI has its own limitations as it is sensitive to the definition of a market, therefore meaning you cannot use it to cross-examine different industries, or do analysis over time as the industry changes. [20]

Relationship between the Herfindahl-Hirschman index and market structure. The greater the Herfindahl-Hirschman value, the greater the market power. Herfindahls index.jpg
Relationship between the Herfindahl-Hirschman index and market structure. The greater the Herfindahl-Hirschman value, the greater the market power.

Lerner index

The Lerner index is a widely accepted and applied method of estimating market power in a monopoly. It compares a firm's price of output with its associated marginal cost where marginal cost pricing is the "socially optimal level" achieved in market with perfect competition. [34] Lerner (1934) believes that market power is the monopoly manufacturers' ability to raise prices above their marginal cost. [35] This notion can be expressed by using the formula:

Where P represents the price of the good set by the firm and MC representing the firm's marginal cost.The formula focuses on the nature of monopoly and emphasising welfare economic implications of the Pareto optimal principle. [36] Although Lerner is usually credited for the price/cost margin index, the generalized version was fully derived prior to WWII by Italian neoclassical economist, Luigi Amaroso. [37]

Elasticity of demand

The degree to which a firm can raise its price above marginal cost depends on the shape of the demand curve at a firm's profit maximising level of output. [38] Consequently, the relationship between market power and the price elasticity of demand (PED) can be summarised by the equation:

The ratio P/MC is always greater than 1 and the higher the P/MC ratio, the more market power the firm possesses. As PED increases in magnitude, the P/MC ratio approaches 1 and market power approaches zero. The equation is derived from the monopolist pricing rule:

Nobel Memorial Prize

Jean Tirole was awarded the 2014 Nobel Memorial Prize in Economic Sciences for his analysis of market power and economic regulation. [39]

See also

Related Research Articles

Microeconomics Behavior of individuals and firms

Microeconomics is a branch of mainstream economics that studies the behavior of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms. Microeconomics focuses on the study of individual markets, sectors, or industries as opposed to the national economy as whole, which is studied in macroeconomics.

A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity. This contrasts with a monopsony which relates to a single entity's control of a market to purchase a good or service, and with oligopoly and duopoly which consists of a few sellers dominating a market. Monopolies are thus characterized by a lack of economic competition to produce the good or service, a lack of viable substitute goods, and the possibility of a high monopoly price well above the seller's marginal cost that leads to a high monopoly profit. The verb monopolise or monopolize refers to the process by which a company gains the ability to raise prices or exclude competitors. In economics, a monopoly is a single seller. In law, a monopoly is a business entity that has significant market power, that is, the power to charge overly high prices, which is associated with a decrease in social surplus. Although monopolies may be big businesses, size is not a characteristic of a monopoly. A small business may still have the power to raise prices in a small industry.

Monopolistic competition Imperfect competition of differentiated products that are not perfect substitutes

Monopolistic competition is a type of imperfect competition such that there are many producers competing against each other, but selling products that are differentiated from one another and hence are not perfect substitutes. In monopolistic competition, a firm takes the prices charged by its rivals as given and ignores the impact of its own prices on the prices of other firms. If this happens in the presence of coercive government, monopolistic competition will fall into government-granted monopoly. Unlike perfect competition, the firm maintains spare capacity. Models of monopolistic competition are often used to model industries. Textbook examples of industries with market structures similar to monopolistic competition include restaurants, cereal, clothing, shoes, and service industries in large cities. The "founding father" of the theory of monopolistic competition is Edward Hastings Chamberlin, who wrote a pioneering book on the subject, Theory of Monopolistic Competition (1933). Joan Robinson published a book The Economics of Imperfect Competition with a comparable theme of distinguishing perfect from imperfect competition. Further work on monopolistic competition was undertaken by Dixit and Stiglitz who created the Dixit-Stiglitz model which has proved applicable used in the sub fields of international trade theory, macroeconomics and economic geography.

An oligopoly is a market form wherein a market or industry is dominated by a small group of large sellers (oligopolists). For example, it has been found that insulin and the electrical industry are highly oligopolist in the US.

In economics, specifically general equilibrium theory, a perfect market, also known as an atomistic market, is defined by several idealizing conditions, collectively called perfect competition, or atomistic competition. In theoretical models where conditions of perfect competition hold, it has been demonstrated that a market will reach an equilibrium in which the quantity supplied for every product or service, including labor, equals the quantity demanded at the current price. This equilibrium would be a Pareto optimum.

In economics, imperfect competition refers to a situation where the characteristics of an economic market do not fulfil all the necessary conditions of a perfectly competitive market, resulting in market failure.

This aims to be a complete article list of economics topics:

The Herfindahl index is a measure of the size of firms in relation to the industry they are in and an indicator of the amount of competition among them. Named after economists Orris C. Herfindahl and Albert O. Hirschman, it is an economic concept widely applied in competition law, antitrust and also technology management. HHI is calculated by squaring the market share of each competing firm in the industry and then summing the resulting numbers,(sometimes limited to the 50 largest firms), where the market shares are expressed as fractions or points. The result is proportional to the average market share, weighted by market share. As such, it can range from 0 to 1.0, moving from a huge number of very small firms to a single monopolistic producer. Increases in the Herfindahl index generally indicate a decrease in competition and an increase of market power, whereas decreases indicate the opposite. Alternatively, if whole percentages are used, the index ranges from 0 to 10,000 "points". For example, an index of .25 is the same as 2,500 points.

In theories of competition in economics, a barrier to entry, or an economic barrier to entry, is a fixed cost that must be incurred by a new entrant, regardless of production or sales activities, into a market that incumbents do not have or have not had to incur. Because barriers to entry protect incumbent firms and restrict competition in a market, they can contribute to distortionary prices and are therefore most important when discussing antitrust policy. Barriers to entry often cause or aid the existence of monopolies and oligopolies, or give companies market power.

In economics, a monopoly is a firm that lacks any viable competition, and is the sole producer of the industry's product. In a normal competitive situation, no firm can charge a price that is significantly higher than the marginal (economic) cost of producing the product. If any firm doing business within a competitive situation tries to raise prices significantly higher than the marginal cost of producing the product, it will lose all of its customers to either other existing firms that charge lower prices, or to a new firm that will find it profitable to use a lower price to take customers away from the firm charging the higher price. But since the monopoly firm does not have to worry about losing customers to competitors, it can set a monopoly price that is significantly higher than its marginal cost, allowing it to have an economic profit that is significantly higher than the normal profit that is typically found in a perfectly competitive industry. The high economic profit obtained by a monopoly firm is referred to as monopoly profit.

Marginal revenue

Marginal revenue is a central concept in microeconomics that describes the additional total revenue generated by increasing product sales by 1 unit. To derive the value of marginal revenue, it is required to examine the difference between the aggregate benefits a firm received from the quantity of a good and service produced last period and the current period with one extra unit increase in the rate of production. Marginal revenue is a fundamental tool for economic decision making within a firm's setting, together with marginal cost to be considered.

The Lerner index, formalized in 1934 by British economist of Russian origin Abba Lerner, is a measure of a firm's market power.

Market structure

Market structure, in economics, depicts how firms are differentiated and categorised based on the types of goods they sell (homogeneous/heterogeneous) and how their operations are affected by external factors and elements. Market structure makes it easier to understand the characteristics of diverse markets.

In economics, market concentration is a function of the number of firms and their respective shares of the total production in a market. The market concentration ratio measures the concentration of the top firms in the market, this can be through various metrics such as sales, employment numbers, active users or other relevant indicators. In theory and in practice, market concentration is closely associated with market competitiveness, and therefore is important to various antitrust agencies when considering proposed mergers and other regulatory issues. Market concentration is important in determining firm market power in setting prices and quantities.

Competition (economics) Rivalry between firms; ability of companies to take each others market share in a given market

In economics, competition is a scenario where different economic firms are in contention to obtain goods that are limited by varying the elements of the marketing mix: price, product, promotion and place. In classical economic thought, competition causes commercial firms to develop new products, services and technologies, which would give consumers greater selection and better products. The greater the selection of a good is in the market, prices are typically lower for the products, compared to what the price would be if there was no competition (monopoly) or little competition (oligopoly). This is because there is now no rivalry between firms to obtain the product as there is enough for everyone. The level of competition that exists within the market is dependant on a variety of factors both on the firm/ seller side; the number of firms, barriers to entry, information availability, availability/ accessibility of resources. The number of buyers within the market also factors into competition with each buyer having a willingness to pay, influencing overall demand for the product in the market.

Edward Chamberlin American economist

Edward Hastings Chamberlin was an American economist. He was born in La Conner, Washington, and died in Cambridge, Massachusetts.

In neoclassical economics, a market distortion is any event in which a market reaches a market clearing price for an item that is substantially different from the price that a market would achieve while operating under conditions of perfect competition and state enforcement of legal contracts and the ownership of private property. A distortion is "any departure from the ideal of perfect competition that therefore interferes with economic agents maximizing social welfare when they maximize their own". A proportional wage-income tax, for instance, is distortionary, whereas a lump-sum tax is not. In a competitive equilibrium, a proportional wage income tax discourages work.

An economic profit is the difference between the revenue a commercial entity has received from its outputs and the opportunity costs of its inputs. Unlike an accounting profit, an economic profit takes into account both a firm's implicit and explicit costs, whereas an accounting profit only relates to the explicit costs which appear on a firm's financial statements. Because it includes additional implicit costs, the economic profit usually differs from the accounting profit.

In microeconomics, the Bertrand–Edgeworth model of price-setting oligopoly looks at what happens when there is a homogeneous product where there is a limit to the output of firms which they are willing and able to sell at a particular price. This differs from the Bertrand competition model where it is assumed that firms are willing and able to meet all demand. The limit to output can be considered as a physical capacity constraint which is the same at all prices, or to vary with price under other assumptions.

Monopoly price

A monopoly price is set by a monopoly. A monopoly occurs when a firm lacks any viable competition, and is the sole producer of the industry's product. Because a monopoly faces no competition, it has absolute market power, and thereby has the ability to set a monopoly price that will be above the firm's marginal (economic) cost. Since marginal cost is the increment in total required to produce an additional unit of the product, the firm would be able to make a positive economic profit if it produced a greater quantity of the product and sold it at a lower price.

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Further references