What is market power?
Market power refers to the relative ability of a company to manipulate the price of an item in the marketplace through the manipulation of the level of supply, demand, or both. Therefore, market power exists if a firm can alter the price of goods or services in the marketplace. A monopolist is said to have market power because he has control over the price and quantity of his product. Thus, the gain to monopolists from exercising market power is price and quantity control. A firm in an oligopoly has less market power compared to a monopolist firm. However, it has more market power compared to a firm under monopolistic competition.
Monopolists can achieve any level of profit they desire because they have unlimited market power. In monopolistic competition, firms can have some market power. The only firms that do not have market power are firms under perfect competition. This is because both buyers and sellers in the market are price takers. A firm lacks market power if it cannot influence the price of a product by manipulating demand, supply, or both. A firm that has significant market power tends to engage in abusive conduct. Moreso, a firm with market power engages in price discrimination to earn a high profit as well as prevent deadweight loss in some cases.
Product differentiation always leads to some measure of market power. A business with market power will typically be more dominant in its industry. For a firm to have market power, it must have a substantial market share. Therefore, market power may result from an increased market share of a firm. A firm has market power if it can affect the supply or demand of a market to manipulate prices in the market. Companies with market power face a trade-off between having a higher marginal cost and a reduction in output. This is because a reduction in costs brings about an increase in profit.
Market power definition
“Market power” is an expression used to indicate that a firm has the ability to manipulate the market price, thereby having control over its profit margin as well as the possibility to increase barriers to potential new entries into the market. We can describe firms that have market power as price makers. This is because they have the ability to establish or adjust the price of an item in the marketplace without relinquishing market share. In other words, they can determine the price of a product even while maintaining market share. Another word for market power is pricing power or economic strength. In essence, market power refers to a company’s relative ability to manipulate the price of an item in the marketplace by manipulating the level of supply, demand, or both.
In a market where there are many producers competing with one another to sell similar products, their market power is limited. That is, in markets with a perfect competition or close to perfect competition, the producers have little economic strength, therefore they must be the price takers. It is unlike the monopolistic and oligopolistic market structures where the economic power of producers is high. By implication, economic strength can be viewed as the level of influence that a company has on determining price in the market. This can be for a specific product or generally within the industry. Firms with market power create deadweight loss because they charge a greater price than the marginal cost in order to increase their profits.
The rise of market power and the macroeconomic implications
In the United States, the loss in economic efficiency due to market power is an externality. A firm operating in an oligopolistic market has more market power compared to a firm operating under monopolistic competition. One of the market failures caused by market power is high prices, which is a negative externality to individuals. Therefore, market power is a form of market failure because it may bring about higher prices of goods and services. This also means that market power and externalities are two possible causes of market failure.
From the above analysis, market power lowers the well-being of consumers. Also, it brings about a decrease in the demand for labor and lowers capital investment. Hence, market power discourages innovation in business.
Types of market power based on the market structure
Different economic systems exist in which firms vary in the ability to control price. Therefore, market power varies which is dependent upon whether the operation of the economy or industry is under perfect competition, monopoly, oligopoly, or monopolistic competition. Let’s look at the types of market power that can be observed in the following various market structures:
There are many firms/organizations in this market and any firm is free to enter or exit the market anytime. Here, firms sell products or services that are homogeneous and they make a normal profit. The firms operating in this system do not have the power to set prices for the whole market. Barriers to entry are not in existence and in the long run, no single firm makes a supernormal profit. Buyers under perfect competition enjoy perfect information with regard to the product or service. Also, the demand for products or services is highly elastic, that is, products under a perfectly competitive market have a perfectly elastic demand. In this case, every firm is a price taker and holds zero market power.
In monopolistic competition, many firms exist in the same industry but they sell differentiated products. These firms share market power, so they can increase the price of their products without losing customers. In other words, sellers can determine prices. Products in the industry are not perfect substitutes for each other.
The demand for products in this market structure becomes elastic in the long run as firms eventually modify their products in order to suit the needs of the market. There are barriers to entry into the industry but these barriers tend to be low. Perfect information with regard to the products is usually unavailable to buyers and sellers. Ambiguity exists whereby exploitation by more knowledgeable players can take place. In monopolistic competition, firms or sellers are price setters, therefore, they hold market power.
A monopoly is a market that has one firm or seller dominating the industry. The gains to monopolists from exercising market power is that they tend to exceed losses to consumers in monopoly markets which results in a net gain to society. Monopolies use their market power to engage in abusive practices sometimes if the government does not regulate them.
Only one supplier of a particular product or service exists in a monopoly. Here, the firm has the ability to increase prices by reducing the level of output or supply which will bring about an increase in the demand for the product. It is at this point that the supplier can raise the price. The demand for products or services in a monopoly is highly inelastic, therefore, the firm has a considerable market or pricing power.
In a monopoly, there are high barriers to entry into the industry as the company enjoys protection by patents. It is difficult for buyers to have access to perfect information and there are cases in which the seller exploits the market by practicing price discrimination. The market power enjoyed by a monopolist is extremely high because of this. However, government regulations can limit the firm’s ability to raise prices.
Monopolistic firms hold the highest market power. This is because the barriers to entry into the industry are high. Therefore, a fundamental source of monopoly market power arises from the ability to control prices through demand and supply. Hence, the two primary factors determining monopoly market power are the firm’s demand curve and cost structure.
Few firms dominate an oligopolistic market and there are barriers to entry. By some type of agreement, firms in an oligopoly have shared market power. In other words, they have combined market power, not individual power. Their pricing power is relatively high.
In an oligopoly, firms can increase their market power by joining a cartel where they work together to determine the output level that each firm will produce as well as the price that each will charge. When the cartel members work together, this gives them the ability to behave like a monopolist.
Sources of market power
- Increasing returns to scale: The firms that experience increasing returns to scale also experience decreasing average total costs. Hence, they become more profitable with size.
- High barriers to entry: This is one of the sources of market power. These barriers include the government-created barriers to entry, control of scarce resources, technological superiority, and increasing returns to scale. For example, OPEC is a firm that has market power due to control over scarce resources (oil).
- High start-up costs: This barrier makes it challenging for new entrants to succeed. Firms such as telecommunication companies, power, and cable television fall within this category. Firms that seek to venture into such industries will have to be able to spend millions of dollars before starting operations and generating revenue.
- Brand loyalty of consumers and value placed by consumers on reputation: Already existing firms usually have a competitive advantage over new entrants. An incumbent firm can engage in several entry-deterring strategies such as strategic bundling, limit pricing, and predatory pricing. For example, Microsoft due to technological superiority in its design and production processes has market power.
- Government policies/regulations: A typical example of policies being a source of market power are patents granted to pharmaceutical companies. During the term of the patent, these patents render the drug companies a virtual monopoly on the protected product.
Factors that determine market power
- Number of competitors in a market
- Elasticity of demand
- Product differentiation
- The ability of firms to make abnormal profits
- Pricing power
- Perfect information
- Barriers to entry or exit
- Factor mobility
- Economies of scale
- Government regulations
- Control of raw materials
- Customer loyalty
The economic strength of firms faces threats when new firms enter the industry. Therefore, as long as barriers to entry exist, a firm’s market power will remain strong.
Number of competitors in a market
For a firm to maintain extensive market power in the industry it operates, there should be no heavy population of competitors. There is an inverse relationship that exists between market power and the number of firms present in the industry or market. This implies that the fewer the companies are, the greater the market power will be for each player.
Elasticity of demand
Another factor that determines economic strength is the elasticity of demand. For a company to have substantial market power, the demand for its products must be inelastic. This implies that a persistent need for the product exists regardless of its price. It is possible for a company to achieve an inelastic demand curve when it provides unique products and services that have the capacity to create value for the customer.
It is easier for a firm to hold an extensive market share when it offers differentiated products and services. To some extent, it will have the ability to dictate the pricing of its products thereby meeting the inelastic demand of customers. Holding a large market share enhances a company’s ability to dictate prices for products.
The ability of firms to make abnormal profit
As earlier pointed out, both buyers and sellers are price takers in the perfectly competitive market. Therefore, it is impossible for firms in such an industry to make an abnormal profit. More firms who seek to generate the same come to join the industry since there are no barriers to entry. In turn, this will dilute each participant’s position in the industry thereby bringing down the profits from abnormal to normal. If a company has great market power, it will be able to make abnormal profits.
A company offering distinguished products and services as well as holding an extensive market share to some extent has the ability to dictate the pricing of its product as well as meet the inelastic demand that comes from customers. By implication, if a company has a high degree of pricing power, it will achieve substantial market power.
If there is a perfect information flow and there is no mismatch existing between facts and available information, firms or participants in the industry will not achieve market power.
Barriers to entry or exit
Barriers to entry into an industry are great determinants of economic strength. This implies that if there are high barriers to entry into an industry, the participants will hold market power. When there are high barriers to entry, this implies that the existing players are enjoying protection because new players do not have easy access to entry as well as disrupting the marketplace. It encompasses the control of scarce resources, increasing scale of production, superiority in technology, and the government implemented barriers to entry. When these barriers exist, it becomes difficult for new entrants to succeed as it may require them to pay a huge amount of money to enter the industry.
If an industry makes provision of equal ease of access to factor inputs of its products or services, this will make the market power of individual firms not to be better off.
Economies of scale
Oftentimes, it happens that the organization has a substantial amount of market share in the market products in a large volume to maximize its profit. If then, a new entrant decides to come in, there will be a need for it to also produce in large quantities as well to keep its cost low compared to market rulers. Therefore, economies of scale are indicators of an organization’s market power in the market.
Government regulations serve as a major factor that determines an organization’s market power. In a market where there are strict numerous regulations, strong control of existing organizations exists. In essence, the higher the government regulations, the lower the market power of firms in an industry will be.
Control of raw materials
The control of the supply of raw materials in the market is an important determinant of market power. An instance is when an organization that has control over the supply of raw materials needed for a product in the market may refuse to sell them at low prices to make manufacturing organizations compete. Therefore, the scarcity of resources/ raw materials plays a significant role in the degree of market power.
As time goes on, an organization tends to build its reputation in the market as well as hold a great image in the eyes of customers. With this, it becomes difficult for customers to switch to other products even at a low price. As a result of brand establishment in the market, an organization’s market power remains high thereby making it difficult for new entrants to gain market share. Consumer loyalty is one of the sources of market power.
How is market power measured?
In the market, one can determine an organization’s share by measuring its market power. The concentration ratio is the most common measure for determining market power which is used to determine a firm’s degree of control in the market. The measure of market power takes place through two common methods
Methods used to measure market power
- Concentration ratios
- Herfindahl-Hirschman Index
We can define the concentration ratios as a measure of market power in relation to the business’s size with that of the size of the product.
Concentration ratios are categorized into two types namely;
- Four-firm concentration ratio
- Eight firm concentration ratio.
Types of concentration ratios
- Four firm concentration ratio: The four-firm concentration ratio refers to the fraction of the output that the top four organizations in the industry produced.
- Eight firm concentration ratio: The eight-firm concentration ratio refers to the fraction of output that the top eight organizations in the industry produced.
Analysts make use of both ratios to make a provision for a clear view of the industry concentration in the market.
For instance, in the United States market, the four largest organizations have a 98 percent share when it comes to the case of cigarettes. The range of these concentration ratios may be from 0 to 100 percent where a concentration of 0 percent indicates that the market is highly competitive and a concentration of 100 percent indicates that the market is highly oligopolistic which also implies that it is an imperfect market.
3 types of concentration under the concentration ratio
- Low concentration
- Medium concentration
- High concentration
Analysts consider the industry to be under low concentration if its concentration ranges from 0 to 50 percent. Monopolistic competition falls to the bottom of this while oligopoly emerges near the upper end.
We can consider the industry to fall under the medium concentration if the range of its concentration ratio is from 50 to 80 percent. The industries that fall under this category are more of an oligopoly.
An industry is considered to have a high concentration when its concentration ratio ranges from 80 to 100 percent. Generally, government regulators fall within this category.
Concentration ratio formula and example
The most commonly used concentration ratio is the four-firm concentration ratio (CR4) where the market shares of the four largest firms in the industry are summed up.
The general formula for calculating the concentration ratio is;
CRn = S1 + S2 + …+ Sn
S = The nth largest company in the industry (in market share)
This formula applies to both the four-firm concentration ratio (CR4) and the eight-firm concentration ratio (CR8)
CR4 = S1 + S2 + S3 + S4
CR8 = S1 + S2 + S3 + S4 +S5 + S6 + S7 + S8
For example, in an industry, the market shares of each form are as follows;
|Firm||Market share (100%)|
For CR4, we will find the sum of the market share of the four largest companies using the formula;
CR4 = S1 + S2 + S3 + S4
CR4 = 33%+22%+15%+12%
CR4 = 82%
From the above calculation, the figure shows that four firms have control over the market. The conclusion is that the market is oligopolistic in nature, therefore, the firms have substantial market power.
Herfindahl-Hirschman index (HHI)
In addition to concentration ratios, another method that analysts use to measure the market power of a firm is Herfindahl-Hirschman Index. This index is used to indicate the competition that exists among organizations in an industry. The HHI, therefore, helps to determine if the industry is competitive or it is heading towards monopoly.
HHI formula and example
The calculation of the HHI takes place by squaring the market share for each firm and summing up the squares. In a perfectly competitive market, this index moves close to zero while in a monopoly, the index moves close to 10,000. That is;
HHI = S12+S22+S32+S42+….Sn2
For example, a market comprises four firms with market shares 30%, 30% 20%, and 20%
Using the formula above,
HHI = 302+302+202+202
HHI = 900+900+400+400
HHI = 2600
As the number of firms in the market decreases as well as the disparity in size between those firms increases, the HHI in the industry increases.
Market power examples
An example of a firm with market power is Google in the search engine industry. Although Google cannot take over the entire market, it has a substantial market share thereby possessing power in the global economy as well as its industry. The balance of market power indicator measures the strength of buyers against sellers through the assessment of the ability of each side to drive prices to an extreme level.
Another example of market power is Apple in the smartphone industry as it has a great influence on the price in the market. As earlier stated, market power refers to a firm’s ability to enforce changes in the market price of a product by manipulating its supply or demand.
Abuse of market power
The abuse of market power is a conduct that is being practiced with the purpose, effect, or likely effect of substantially lessening competition in the market. A business that has a substantial degree of market power is not allowed to engage in such conduct or behavior. However, it is not illegal for a firm to seek to achieve market power by providing the best products and services.
The presence of competitors in the market usually constrains the ability of a firm to raise its prices. There is a possibility that customers will switch to alternative sources of supply if a firm raises its prices. We can say that a firm has market power if these constraints are weak. It can be in a position of dominance, say a monopoly.
Possessing a monopoly power in itself does not imply the violation of the laws guiding competition but weakening competition and excluding rivals. If a firm indulges in this act, there will be a need for intervention from competition authorities.
Detecting abuse of market power
As opposed to competition, determining whether the action of a firm is an abuse of market power can be complex and controversial in nature. However, competition laws typically contain provisions that prohibit the abuse of market power by firms that dominate the industry. These provisions vary across jurisdictions.
It is important for competition authorities to have a proper understanding of when the actions of a firm could be considered abusive. This is because an incorrect intervention can be harmful to consumers and the economy. It is also necessary for a dominant firm with a large market share to understand the competition laws.
Examples of abusive practices
1. Economic withholding
2. Physical withholding
The examples of abusive practices are not limited to the above-mentioned.
This is a situation whereby a large supplier makes use of his economic power to drive wholesale prices high. Here, the supplier offers some energy at prices that are significantly higher than its marginal costs. On several occasions, these offers make market prices become clearly higher than they would have if the energy is being offered closer to marginal cost.
A supplier can decide to retire a number of older units with most of its generating capacities located close to a load pocket. In this case, the market monitor can investigate whether these retirements are economically justifiable or whether they can increase the ability of a supplier to control prices in the load pocket.
FAQs on market power
What are the types of market power?
The types of market power are perfect competition power, monopolistic competition power, monopoly power, and oligopoly power
What is the correct ranking of the degree of market power?
The correct ranking of the degree of market power (from highest to lowest) is a monopoly, oligopoly, monopolistic competition, or perfect competition.
What effect might market power have on technological change?
Market power results in economic efficiency thereby eliminating the need for a new technology to be in place.
What is the definition of market power in economics?
Market power is the ability of a firm to influence the price of an item in the marketplace.
Which market structure is characterized by the absence of market power?
The market structure that is characterized by the absence of market power is perfect competition. This is because both the buyers and sellers are price takers. That is, firms do not have the power to manipulate the price of their products because prices are determined by the forces of supply and demand.
Firms in which market structure holds the most market power?
Firms in a monopoly have the most market power. This is because a monopoly is characterized by a single supplier in the industry with no close substitute for its products. Therefore, a monopolist is a price maker and has the power to manipulate the price of its product. Also, the products of a monopolist possess inelastic demand.
How do network externalities help a monopoly retain its market power?
If network externalities exist for a product, then other goods become poor substitutes for it. Goods with network externalities have higher chances of receiving government patents. This helps a monopolist retain his market power.
Which type of merger is more likely to increase the market power of a newly merged firm?
Horizontal merger. This is because, in a horizontal merger, it is two or more firms selling the same products that come together to form a single entity. The new firm becomes bigger, so they tend to increase market power.
What do firms stand to gain by increasing their market power?
A firm that has market power has the ability to influence prices in the market. So, what a firm stands to gain by increasing market power is that it can increase prices without losing its customers. It implies that the firm is increasing revenues without increasing its costs.
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