Market power

Market power

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Encyclopedia
In economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

, market power is the ability of a firm
Theory of the firm
The theory of the firm consists of a number of economic theories that describe the nature of the firm, company, or corporation, including its existence, behavior, structure, and relationship to the market.-Overview:...

 to alter the market price
Market price
In economics, market price is the economic price for which a good or service is offered in the marketplace. It is of interest mainly in the study of microeconomics...

 of a good or service. In perfectly competitive
Perfect competition
In economic theory, perfect competition describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. Because the conditions for perfect competition are strict, there are few if any perfectly competitive markets...

 markets, market participants have no market power. A firm with market power can raise prices without losing its customers to competitors. Market participants that have market power are therefore sometimes referred to as "price makers," while those without are sometimes called "price takers."

A firm with market power has the ability to individually affect either the total quantity or the prevailing price in the market. Price makers face a downward-sloping demand curve
Demand curve
In economics, the demand curve is the graph depicting the relationship between the price of a certain commodity, and the amount of it that consumers are willing and able to purchase at that given price. It is a graphic representation of a demand schedule...

, such that price increases lead to a lower quantity demanded. The decrease in supply as a result of the exercise of market power creates an economic deadweight loss
Deadweight loss
In economics, a deadweight loss is a loss of economic efficiency that can occur when equilibrium for a good or service is not Pareto optimal...

 which is often viewed as socially undesirable. As a result, many countries have anti-trust 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.

A firm usually has market power by virtue of controlling a large portion of the market. In extreme cases - monopoly
Monopoly
A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...

 and monopsony
Monopsony
In economics, a monopsony is a market form in which only one buyer faces many sellers. It is an example of imperfect competition, similar to a monopoly, in which only one seller faces many buyers...

 - the firm controls the entire market. However, market size alone is not the only indicator of market power. Highly concentrated markets
Market concentration
In economics, market concentration is a function of the number of firms and their respective shares of the total production in a market...

 may be contestable
Contestable market
In economics, the theory of contestable markets, associated primarily with its 1982 proponent William J. Baumol, holds that there exist markets served by a small number of firms, which are nevertheless characterized by competitive equilibria because of the existence of potential short-term...

 if there are no barriers to entry
Barriers to entry
In theories of competition in economics, barriers to entry are obstacles that make it difficult to enter a given market. The term can refer to hindrances a firm faces in trying to enter a market or industry - such as government regulation, or a large, established firm taking advantage of economies...

 or exit, limiting the incumbent firm's ability to raise its price above competitive levels.

Market power gives firms the ability to engage in unilateral anti-competitive behavior
Anti-competitive practices
Anti-competitive practices are business or government practices that prevent or reduce competition in a market .- Anti-competitive practices :These can include:...

. Some of the behaviours that firms with market power are accused of engaging in include predatory pricing
Predatory pricing
In business and economics, predatory pricing is the practice of selling a product or service at a very low price, intending to drive competitors out of the market, or create barriers to entry for potential new competitors. If competitors or potential competitors cannot sustain equal or lower prices...

, product tying, and creation of overcapacity
Capacity utilization
Capacity utilization is a concept in economics and managerial accounting which refers to the extent to which an enterprise or a nation actually uses its installed productive capacity...

 or other barriers to entry. If no individual participant in the market has significant market power, then anti-competitive behavior can take place only through collusion
Collusion
Collusion is an agreement between two or more persons, sometimes illegal and therefore secretive, to limit open competition by deceiving, misleading, or defrauding others of their legal rights, or to obtain an objective forbidden by law typically by defrauding or gaining an unfair advantage...

, or the exercise of a group of participants' collective market power.

The Lerner index and Herfindahl index
Herfindahl index
The Herfindahl index is a measure of the size of firms in relation to the industry 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...

 may be used to measure market power.

Oligopoly


When several firms control a significant share of market sales, the resulting market structure is called an oligopoly
Oligopoly
An oligopoly is a market form in which a market or industry is dominated by a small number of sellers . The word is derived, by analogy with "monopoly", from the Greek ὀλίγοι "few" + πόλειν "to sell". Because there are few sellers, each oligopolist is likely to be aware of the actions of the others...

 or oligopsony
Oligopsony
An oligopsony is a market form in which the number of buyers is small while the number of sellers in theory could be large. This typically happens in a market for inputs where numerous suppliers are competing to sell their product to a small number of buyers...

. An oligopoly may engage in collusion
Collusion
Collusion is an agreement between two or more persons, sometimes illegal and therefore secretive, to limit open competition by deceiving, misleading, or defrauding others of their legal rights, or to obtain an objective forbidden by law typically by defrauding or gaining an unfair advantage...

, either tacit or overt, and thereby exercise market power. An explicit agreement in an oligopoly to affect market price or output is called a cartel
Cartel
A cartel is a formal agreement among competing firms. It is a formal organization of producers and manufacturers that agree to fix prices, marketing, and production. Cartels usually occur in an oligopolistic industry, where there is a small number of sellers and usually involve homogeneous products...

. The behavior of firms in perfect competition or monopoly can be treated as a simple optimization
Optimization (mathematics)
In mathematics, computational science, or management science, mathematical optimization refers to the selection of a best element from some set of available alternatives....

, but an oligopoly requires game theoretic
Game theory
Game theory is a mathematical method for analyzing calculated circumstances, such as in games, where a person’s success is based upon the choices of others...

 analysis.

Monopoly power


Monopoly power is an example of market failure
Market failure
Market failure is a concept within economic theory wherein the allocation of goods and services by a free market is not efficient. That is, there exists another conceivable outcome where a market participant may be made better-off without making someone else worse-off...

 which occurs when one or more of the participants has the ability to influence the price
Price
-Definition:In ordinary usage, price is the quantity of payment or compensation given by one party to another in return for goods or services.In modern economies, prices are generally expressed in units of some form of currency...

 or other outcomes in some general or specialized market
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...

. The most commonly discussed form of market power is that of a monopoly
Monopoly
A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...

, but other forms such as monopsony
Monopsony
In economics, a monopsony is a market form in which only one buyer faces many sellers. It is an example of imperfect competition, similar to a monopoly, in which only one seller faces many buyers...

, and more moderate versions of these two extremes, exist.

A well known example of monopolistic market power is Microsoft's
Microsoft
Microsoft Corporation is an American public multinational corporation headquartered in Redmond, Washington, USA that develops, manufactures, licenses, and supports a wide range of products and services predominantly related to computing through its various product divisions...

 market share in PC
IBM PC compatible
IBM PC compatible computers are those generally similar to the original IBM PC, XT, and AT. Such computers used to be referred to as PC clones, or IBM clones since they almost exactly duplicated all the significant features of the PC architecture, facilitated by various manufacturers' ability to...

 operating system
Operating system
An operating system is a set of programs that manage computer hardware resources and provide common services for application software. The operating system is the most important type of system software in a computer system...

s. The United States v. Microsoft
United States v. Microsoft
United States v. Microsoft was a set of civil actions filed against Microsoft Corporation pursuant to the Sherman Antitrust Act of 1890 Section 1 and 2 on May 8, 1998 by the United States Department of Justice and 20 U.S. states. Joel I. Klein was the lead prosecutor...

case dealt with an allegation that Microsoft illegally exercised its market power by bundling its web browser
Web browser
A web browser is a software application for retrieving, presenting, and traversing information resources on the World Wide Web. An information resource is identified by a Uniform Resource Identifier and may be a web page, image, video, or other piece of content...

 with its operating system.
In this respect, the notion of dominance and dominant position in EU Antitrust Law is a strictly related aspect.

Source of Market Power


A monopoly can raise prices and retain customers because the monopoly has no competitors. If a customer has no other place to go to obtain the goods or services, they either pay the increased price or do without. Thus the key to market power is to preclude competition through high barriers of entry. Barriers to entry that are significant sources of market power are control of scarce resources, increasing returns to scale, technological superiority and government created barriers to entry. OPEC is an example of an organization that has market power due to control over scarce resources - oil. Increasing returns to scale are another important source of market power. Firms experiencing increasing returns to scale are also experiencing decreasing average total costs. Firms in such industries become more profitable with size. Therefore over time the industry is dominated by a few large firms. This dominance makes it difficult for start up firms to succeed. Firms like power companies, cable television companies and wireless communication companies with large start up costs fall within this category. A company wishing to enter such industries must have the financial ability to spend millions of dollars before starting operations and generating any revenue. Similarly established firms also have a competitive advantage over new firms. An established firm threatened by a new competitor can lower prices to drive out the competition. Microsoft is a firm that has substantial pricing or market power due to technological superiority in its design and production processes. Finally government created barriers to entry can be a source of market power. 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.

Measuring Market Power


Concentration ratios are the most common measures of market power. The four-firm concentration ratio measures the percentage of total industry output attributable to top four industries. For monopolies the four firm rartion is 100 per cent while the ratio is zero for perfect competition. Another measure of concentration is the Herfindahl-Hirschman Index
Herfindahl index
The Herfindahl index is a measure of the size of firms in relation to the industry 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...

 which is calculated by "summing the squares of the percentage market shares of all participants in the market." The HHI index for perfect competition is zero; for monopoly, 10,000. The four firm concentration domestic (U.S) ratios for cigarettes is 93%; for automobiles, 84% and for beer, 85%.

Market Power and Elasticity of demand


Market power is the ability to raise price above marginal cost and earn a positive profit. The degree to which a firm can raise price above marginal cost depends on the shape of the demand curve at the profit maximizing output. That is, elasticity is the critical factor in determining market power. The relationship between market power and the Price Elasticity of Demand can be summarized by the equation:
P/MC = PED/(1 + PED)


Note that PED will be negative, so the ratio is always greater than one. The higher the P/MC ratio, the more market power the firm possesses. As PED increases in magnitude, the P/MC ratio approaches one, and market power approaches zero.
The equation is derived from the monopolist pricing rule:/P = -1/PED

See also

  • Bargaining power
    Bargaining power
    Bargaining power is a concept related to the relative abilities of parties in a situation to exert influence over each other. If both parties are on an equal footing in a debate, then they will have equal bargaining power, such as in a perfectly competitive market, or between an evenly matched...

  • Imperfect competition
    Imperfect competition
    In economic theory, imperfect competition is the competitive situation in any market where the conditions necessary for perfect competition are not satisfied...

  • Market concentration
    Market concentration
    In economics, market concentration is a function of the number of firms and their respective shares of the total production in a market...

  • Monopsony
    Monopsony
    In economics, a monopsony is a market form in which only one buyer faces many sellers. It is an example of imperfect competition, similar to a monopoly, in which only one seller faces many buyers...

  • Natural monopoly
    Natural monopoly
    A monopoly describes a situation where all sales in a market are undertaken by a single firm. A natural monopoly by contrast is a condition on the cost-technology of an industry whereby it is most efficient for production to be concentrated in a single form...

  • Predatory pricing
    Predatory pricing
    In business and economics, predatory pricing is the practice of selling a product or service at a very low price, intending to drive competitors out of the market, or create barriers to entry for potential new competitors. If competitors or potential competitors cannot sustain equal or lower prices...

  • Price discrimination
    Price discrimination
    Price discrimination or price differentiation exists when sales of identical goods or services are transacted at different prices from the same provider...

  • Dominance (economics)
    Dominance (economics)
    Market dominance is a measure of the strength of a brand, product, service, or firm, relative to competitive offerings. There is often a geographic element to the competitive landscape...

  • Comcast
    Comcast
    Comcast Corporation is the largest cable operator, home Internet service provider, and fourth largest home telephone service provider in the United States, providing cable television, broadband Internet, and telephone service to both residential and commercial customers in 39 states and the...

    (This link is not relevant)

Further references

  • Managerial Economics and Organizational Architecture 3rd Edition, Brickley, Smith and Zimmerman, McGraw-Hill, Chapter 7.