What’s it: Market power is the firm’s ability to influence its products’ prices in the market. Market power enables firms to charge a higher price than the equilibrium price in a competitive market.
We call companies having market power as price makers. Meanwhile, those who do not have it are referred to as price takers.
On the other hand, in a perfectly competitive market, the firm does not have fan price power, only acts as a price taker. They use the market price as the selling price of their products. And it equals marginal cost.
Thus, if firms have market power, they can set prices above marginal cost. The higher the difference between the selling price and the marginal cost, the higher their profitability.
Firms have market power if they can dominate market supply. Or, they differentiate the offering, allowing them to charge a premium.
Why market power matters
For companies, market power is an essential source for generating long-term economic profit. They can raise prices without losing customers. Also, they can maintain high prices over time.
On the other hand, consumers have to pay a higher price. It might not be a problem if they get the satisfaction (utility) worth the money they paid.
However, sometimes, the price is unreasonable with satisfaction. When the firm is too dominant, it charges high prices for low-quality products as in a monopoly. In other words, companies abuse market power to carry out anticompetitive business practices.
For such reasons, regulators closely monitor any activity that results in increased market power, such as in mergers or acquisitions.
Market power in each market structure
Market power exists in imperfectly competitive markets such as monopolistic competition, oligopoly, and monopoly.
On the other hand, under perfect competition, companies do not have it. They set the price at market price l, which equals marginal cost.
A perfectly competitive market consists of many players of similar size. The output market share of each company is also relatively small. Thus, they cannot influence market output by changing their level of production.
Apart from that, the products are also homogeneous and identical. So, they substitute each other perfectly. There is no reason for consumers to prefer one company’s products over another. Perfect information, low entry barriers, and minimal switching costs also limit firms from gaining market power.
Under monopolistic competition, firms have some market power. Companies can charge higher prices through differentiation, such as advertising and other non-pricing strategies.
However, market power is relatively low because the market products are relatively similar, although not identical. They act as close substitutes for each other. The market also comprises many small players and the entry barriers are low, limiting the firm’s power.
In an oligopoly market, firms enjoy substantial market power. This originates from high entry barriers, the domination of supply, and product differentiation. Companies differentiate their products on aspects such as quality, features, and other non-price strategies.
Since the market comprises a few players, joint coordination to influence market prices is easier. That incentivizes players to collude or form cartels. Such anticompetitive practices increase market power among players.
Furthermore, in the oligopoly market, several players dominate and control a substantial market share. They can influence supply and market prices without colluding.
Lastly, market power is absolute in a monopoly market. The market consists of one player, which determines the supply, quality, and market price. Because threats of substitutes and new entrants are low, the monopolist can maintain its power over time.
However, market power diminishes when the government intervenes in the market. To maintain affordability for consumers, the government may set a maximum price for output as, in most cases, natural monopolies.
Factors affecting market power
Market power depends on factors such as:
- Number and size of companies
- Demand elasticity
- Product differentiation
- Information imperfections
- Entry barrier
- Availability of substitute products and switching costs
Number of companies in a market
The number and size of each company determine how strongly they can influence the market. If the market consists of many players of relatively similar size, market power is low. An example of an extreme case is perfect competition, where each company does not have market power.
Meanwhile, suppose the number of players is small, and the size of the business varies. In that case, market forces are likely to be present. Few firms dominate supply and can influence output and market prices. Such markets usually lead to oligopoly. Apart from doing it individually, players can also collude or form cartels to increase their strength.
Furthermore, in the case of monopoly, market power is absolute. The market consists of one producer, thus determining the market’s quantity, quality, and price. Monopolists can sell volumes at will – in the absence of government regulations – or impose price discrimination to maximize profits.
Market forces allow firms to raise prices above marginal cost and earn an economic profit. The extent to which firms can raise prices above marginal cost depends on the demand curve’s shape. Or in other words, it depends on the elasticity of demand.
The elasticity of demand shows you how responsive demand is when prices change. Demand is elastic if the change in price affects the quantity demanded more significantly. Say, prices fell by 10%. It increases the quantity demanded by more than 10%.
Conversely, when the demand is unresponsive, we call it inelastic. A 10% price reduction causes an increase in the quantity demanded of less than 10%. Likewise, when the price increases by 10%, the quantity demanded falls by less than 10%.
In general, the more inelastic a firm’s demand is, the greater its market power. Consumers have limited alternatives, either for reasons such as high switching costs or limited product substitutions. Therefore, they continue to buy even though the firm raises prices above marginal cost.
However, when demand is elastic, firms cannot charge costs far above their marginal costs. They know consumers will quickly switch to substitutes if the price is too high.
Product differentiation increases market power. That allows consumers to be more loyal to the company’s offerings. Products offer features that are unavailable in competing products. When consumers are loyal, they are relatively less sensitive to price increases.
An example is the iPhone. Apple designs it to be an innovative and imaginative product, allowing it to sell at a premium. Consumers love it and are willing to queue to get the latest edition.
The nature of the interactions between firms is also an important determinant of market power. If firms interact collectively to set prices, then they will be able to keep prices high. Therefore, they collectively have market power.
If collusion occurs formally, we call it a cartel. An example of a cartel is OPEC in the petroleum industry. Member countries take a joint policy regarding production level, where the ultimate goal is to influence market prices.
Imperfect information also gives rise to market forces. In this case, the consumer does not have all the information necessary to make informed decisions about the price or quality.
In contrast, producers have more information about the quality or price of the product than consumers. Hence, they will tend to trick consumers by charging high prices. Not knowing, some consumers may simply accept it without haggling.
The entry barrier affects the number of players, supply, and prices in the market. Among sources of entry barriers are control over scarce resources, technological advantages, economies of scale, and government-created barriers to entry (such as through regulation).
If the barriers to entry are low, the threat of new entrants is high. It is unlikely that existing firms have price power. When existing firms raise prices, it attracts new entrants. They easily enter the market, bring in new capacity, and lower prices.
Conversely, when the barriers to entry are high, the number of firms will be relatively constant. The threat of capacity building from new entrants is also low. Thus, existing companies are more flexible in setting selling prices and are protected from increased competition.
Availability of substitute products and switching costs
If the market has a variety of substituted products, market power is low. When increasing prices, customers will switch to substitute products.
Switching opportunities are higher when switching costs are low. Consumers do not incur additional costs or efforts to obtain and use substituted products.
Market power effects
The first is a decrease in output. The dominant firm can limit production to raise market prices. It can also happen if firms in the market collude or form cartels.
Second, consumers get higher prices. A decrease in output raises the price in the market. It leads to a decrease in economic well-being as consumers have to pay prices above levels that would prevail in competition.
Third, market forces give rise to deliberate anticompetitive behavior. Collusion and cartels are examples. The dominant firm can also use its power to reduce competition, for example, by adopting predatory pricing. Predators set prices at loss levels to drive competitors out of the market while creating entry barriers.
When the intensity of competition decreases, predators are freer to increase prices. They maintain high prices to compensate for losses during adopting predatory pricing and maximizing profits in the long run.
The fourth is strict supervision by regulators. Anticompetitive behavior is detrimental to consumers. The regulator then launches several regulations, such as the antitrust law. They also manage several activities that are a source of increasing market power, such as mergers and acquisitions.
Fifth, the price is lower. Market forces are not always bad. It is necessary for some industries such as electricity, which has high fixed costs. In these industries, economies of scale and average costs fall only if they produce massive outputs. More players mean lower economies of scale and higher prices.
Therefore, to sell at a lower price, the industry needs fewer players. In fact, the industry may only need one firm (natural monopoly).
Natural monopolies are usually under strict government scrutiny to avoid abusing market forces. The government can limit the maximum selling price or appoint a state-owned company to operate in the industry.
Measure market power
One approach to measuring market power is the Lerner Index. It measures the extent to which prices exceed marginal costs. Here is the Lerner index formula:
Lerner’s index (L) = (P – MC) / P
- P is the price,
- MC is marginal cost, and
- E is the elasticity of demand.
A positive Lerner index (L≥0) indicates that the company has monopoly power. The selling price exceeds the marginal cost. The higher the index, the more significant the difference between prices and marginal costs, the greater the market power.
Meanwhile, when the Lerner index is equal to zero (L = 0), it does not have market power. Firms only charge prices at marginal cost levels. In other words, the company operates in a perfectly competitive market.
One of the obstacles to using this indicator is calculating the marginal cost. For internal companies, calculations may be easy because management has data on outputs and costs. However, empirically calculating competitor’s market power is difficult due to data limitations. As an alternative, we can replace it with the average variable cost.