Market power


In economics, market power refers to the ability of a firm to influence the price at which it sells a product or service by manipulating either the supply or demand of the product or service to increase economic profit. In other words, market power occurs if a firm does not face a perfectly elastic demand curve and can set its price above marginal cost without losing revenue. 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. The size of the gap, which encapsulates the firm's level of market dominance, is determined by the residual demand curve's form. A steeper reverse demand indicates higher earnings and more dominance in the market. Such propensities contradict perfectly competitive markets, where market participants have no market power, P = MC and firms earn zero economic profit. 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'.
The market power of any individual firm is controlled by multiple factors, including but not limited to, their size, the structure of the market they are involved in, and the barriers to entry for the particular market. 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. 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 and a decline in consumer surplus. 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. 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. 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. 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. 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.
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.

Market structure

In economics, market structure can profoundly affect the behavior and financial performance of firms. Market structure depicts how different industries are characterized and differentiated based upon the types of goods the firms sell and the nature of competition within the industry. The degree of market power firms assert in different markets depend on 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. Perfect competition and monopoly represent the two extremes of market structure, respectively. Monopolistic competition and oligopoly exist in between these two extremes.

Perfect competition power

"Perfect Competition" refers to a market structure that is devoid of any barriers or interference and describes those marketplaces where neither corporations nor consumers are powerful enough to affect pricing. In terms of economics, it is one of the many conventional market forms and the optimal condition of market competition. 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. 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 and must accept the price given by the market. 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.

Monopolistic competition power

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. 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. 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. 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, setting individual prices for the unique differentiated products. 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. 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. Firms with monopoly power can charge a higher price for products as demand is relatively inelastic. They also see a falling rate of labour share as firms divest from expensive inputs such as labour. 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
  3. Control of key resources
  4. Legal regulations
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.

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. The emergence of oligopoly market forms is mainly attributed to the monopoly of market competition, i.e., the market monopoly acquired by enterprises through their competitive advantages, and the administrative monopoly due to government regulations, such as when the government grants monopoly power to an enterprise in the industry through laws and regulations and at the same time imposes certain controls on it to improve efficiency. The main characteristics of an oligopoly are:
  1. A few sellers and many buyers.
  2. Homogenous or differentiated products.
  3. High barriers to entry. This includes, but is not limited to, 'technology challenges, government regulations, patents, start-up costs, or education and licensing requirements'.
  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. For firms trying to enter these industries, unless they can start with a large production scale and capture a significant market share, the high average costs will make it impossible for them to compete with the existing firms. 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. It is important to note that this graph is a simplistic example of a 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, 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.
An oligopoly may engage in collusion, either tacit or overt to exercise market power and manipulate prices to control demand and revenue for a collection of firms. A group of firms that explicitly agree to affect market price or output is called a cartel, with the organization of petroleum-exporting countries being one of the most well known example of an international cartel.