What’s it: Monopoly power refers to a firm’s ability to influence market prices. It is weak when the market is made up of many players, and products are relatively homogeneous. Market power is higher when firms operate under an oligopoly, where the market consists of only a few firms. And, the firm has absolute market power if it is the only producer in the market (monopoly).
Monopoly power is synonymous with market power and is often used interchangeably in some literature.
The relationship between monopoly power and market structure
Monopoly power is often contrasted with a price taker. When a company is a price taker, it has no control over their products’ selling price, let alone influence the market price. It only takes the market price as the selling price of its products. Price takers work in a perfectly competitive market.
In a monopolistic competitive market, firms have some power to set prices. They do this by differentiating the offer. One way is to differentiate product features or branding through advertising. Differentiation allows the company to set a selling price that is higher than the market price.
Furthermore, monopoly power is getting more significant in the oligopoly market. Because the market comprises a few firms, firms have more market power than monopolistic competitive markets. The fewer players, the higher the power over the selling price.
Under an oligopoly market, competition has a more intriguing dimension. I mean, in designing strategy, companies are likely to observe strategic decisions made by their opponents. Or, they may collude or form cartels.
Finally, the power over market prices is absolute in a monopoly market. The monopolist determines supply, product quality, and selling price because it is the sole supplier.
The monopolist has neither direct competitors nor threats from substitute products. Barriers to entry are also very high, allowing the company to maintain its power. Furthermore, the customer doesn’t have the option to switch to another product because there is no substitute product.
What affects monopoly power
The significance of monopoly power depends on:
- Market entry barriers. The higher the entry barriers, the higher the company’s chance to gain and maintain monopoly power. New entrants bring new capacities to the market and add choices for consumers. Suppose the current firm charges a higher price than the equilibrium price. In that case, the new entrant may offer at the equilibrium price, encouraging more purchases.
- The number of rivals. The fewer players, the greater the monopoly power. As I explained earlier, market power in perfect competition is zero. It will increase when the market leads to monopoly. Moreover, if the market consists of a few players, it was easy for them to collude in setting prices.
- Product differentiation. Differentiation increases a firm’s ability to set a selling price. Conversely, when producing a homogeneous product (mass product), the power over the selling price decreases. Once the company charges a higher price than other players, consumers will switch to cheaper products. Long story short, differentiation increases consumer switching costs.
Sources of monopoly power
Market power comes from a variety of sources, including:
- Economies of scale
- Resource control
- Demand elasticity
- Legal barriers
Economies of scale
To achieve economies of scale and lower costs, it requires a few players. In fact, the market might require only one company to produce cheap output.
Such situations will eventually lead to monopoly, which we often refer to as a natural monopoly. The most common examples are in the electrical industry.
Firms also have influence over market prices if they have control over resources essential to production. Companies can limit competitors to obtain the same resources. Competitors may have to pay more to access resources.
So, indirectly, the resource authority will influence the cost structure in the market, which impacts the price in the market.
The company is better positioned to charge prices higher than its marginal cost if demand elasticity is low (demand is relatively inelastic). Conversely, if the elasticity of demand is high (demand is relatively elastic), the firm has less market power.
Economists use the Lerner Index to measure market strength. This index basically measures the price markup on marginal cost.
Lerner’s index (L) = (P – MC) / P = 1 / | E |
Where P is price, MC is marginal cost and E is the elasticity of demand.
When Lerner’s index is positive (L≥0), the firm has monopoly power. They can charge more than their marginal cost—the greater the index value, the greater the monopoly power.
Furthermore, in perfect competition, Lerner’s Index is equal to zero (L = 0). The firm does not have the power to influence market prices and charge the selling price at a marginal cost level—the closer to 0, the closer to perfect competition.
Monopoly power also arises because of regulatory support. The government may only permit one company to operate in the market. Usually, it is for strategic industries such as utilities and the weapons industry.
Not only that, but the granting of patents, copyrights, licenses, protection of other intellectual property rights also contributes to market power. Such protection prevents others from copying or selling an innovation. Only the owner can monetize it.
The effects of monopoly power on market failure
Market failures arise when market mechanisms don’t work. The selling price doesn’t reflect the equilibrium price. Producers will take advantage by setting a price higher than the equilibrium price. As a result, the consumer surplus decreases.
An extreme case is perfect price discrimination in a monopoly market. The monopolist sets the selling price at the consumer reservation price level. The reservation price is the highest price a consumer is willing to pay.
Because each consumer has a different reservation price, the monopolist will set a different price for each customer, according to the reservation price. In this way, the monopolist can maximize profits and convert the total consumer surplus into producer surplus.
How to reduce monopoly power
Monopoly power isn’t always detrimental, as long as the product’s price matches consumers’ satisfaction. Despite paying higher prices, consumers get a higher quality product.
Moreover, in natural monopoly, the market would be more beneficial if it consisted of only one player. That way, the average cost drops, and the selling price is more affordable.
But, in more and more cases, monopoly power hurts consumers. They pay higher prices for unqualified products. There are various ways to reduce monopoly power, including:
- Deregulation – The government may issue several regulations for several industries. But, if the industry continues to be inefficient and innovative, it can release regulations to open up more competition. For example, increasing the limits on foreign ownership in specific industries.
- Privatization – This is to reduce the state monopoly in the economic sector. In this case, the government sold state-owned companies to the private sector.
- Competition rules – for example, antitrust laws. Such regulation prevents unfair competition practices that lead to increased monopoly power.