Market power

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 (homogenous/heterogenous) 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. 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: • Producers sell homogenous goods • All firms are price takers • Perfect information • No barriers to enter and exit • 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 Monopolistic competition 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: • Differentiated products • Many sellers and buyers • 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 (higher markup) 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: • Economies of scale • Predatory pricing 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: • A few sellers and many buyers. • Homogenous or differentiated products. • High barriers to entry. This includes, but is not limited to, 'technology challenges, government regulations, patents, start-up costs, or education and licensing requirements'. • 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. 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 (P*), 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 (OPEC) being one of the most well known example of an international cartel. ==Sources of market power==

By remaining consistent with the strict definition of market power as any firm with a positive Lerner index, the sources of market power is derived from distinctiveness of the good and or seller. For a monopolist, distinctiveness is a necessary condition that needs to be satisfied but this is just the starting point. Without barriers to entries, above normal profits experienced by monopolists would not persist as other sellers of homogenous or similar goods would continue to enter the industry until above normal profits are diminished until the industry experiences perfect competition OPEC is an example of an organization that has market power due to control over scarce resources – oil. • Increasing returns to scale. Firms that experience increasing returns to scale also experience decreasing average total costs and therefore become more profitable with size and higher demand levels. A prime example are patents granted to pharmaceutical companies which prevent competitors from creating and selling their specific goods. These patents give the drug companies a virtual monopoly in the protected product for the term of the patent. • Factors of Production Barriers. An important influencing factor of market power is the control of the supply of factors of production to produce the good. Factors of production can be divided into tangible land, capital, and intangible human resources, intelligence, etc. As the industrial economy changes to a knowledge-based economy, the control of the supply of intangible factors of production such as talent, intelligence, information, etc. will become more and more of a barrier to entry for companies with unlimited market power. ==Measurement of market power==

Measuring market power is inherently complex because the most widely used measures are sensitive to the definition of a market and the range of analysis. Magnitude of a firm's market power is shown by a firm's ability to deviate from an elastic demand curve and charge a higher price (P) above its marginal cost (C), commonly referred to as a firm's markup. The higher a firm's markup, the larger the magnitude of power. This said, markups are complicated to measure as they are reliant on a firm's marginal costs and as a result, concentration ratios are the more common measures as they require only publicly accessible revenue data. Concentration ratios Market concentration, also referred to as industry concentration, refers to the extent of which market shares of the largest firms in the market account for a significant portion of the economic activities quantifiable by various metrics such as sales, employment, active users. Recent macroeconomic market power literature indicates that concentration ratios are the most frequently used measure of market power. Moreover, studies indicate that a concentration ratio of between 40 and 70 percent suggests that the firm operates as an oligopoly. These figures are viable but should be used as a 'rule of thumb' as it is important to consider other market factors when analysing concentration ratios. An advantage of concentration ratios as an empirical tool for studying market power is that it requires only data on revenues and is thus easy to compute. The corresponding disadvantage is that concentration is about relative revenue and includes no information about costs or profits. Herfindahl-Hirschman index The Herfindahl-Hirschman index (HHI) is another measure of concentration and is the sum of the squared market shares of all firms in a market. The HHI is a more widely used indicator in economics and government regulation. The index reflects not only the market share of large firms within the market, but also the market structure outside of large firms, and therefore, more accurately reflects the degree of influence of large firms on the market. For example, in a market with two firms, each with 50% market share, the HHI is \sum(S_i)^2 = 0.502 + 0.502 = 0.50. The HHI for a monopoly is 1 whilst for perfect competition, the HHI is zero. Unlike the N-firm concentration ratio, large firms are given more weight in the HHI and as a result, the HHI conveys more information. However the HHI has its own limitations as it is sensitive to the definition of a market, therefore meaning you cannot use it to cross-examine different industries, or do analysis over time as the industry changes. Lerner (1934) believes that market power is the monopoly manufacturers' ability to raise prices above their marginal cost. This notion can be expressed by using the formula: :L = (P-MC)/P Where P represents the price of the good set by the firm and MC representing the firm's marginal cost. The formula focuses on the nature of monopoly and emphasising welfare economic implications of the Pareto optimal principle. Although Lerner is usually credited for the price/cost margin index, the generalized version was fully derived prior to WWII by Italian neoclassical economist, Luigi Amaroso. ==Connection with competition law==

Market power within competition law can be used to determine whether or not a firm has unfairly manipulated the market in their favour, or to the detriment of entrants. The Sherman Antitrust Act of 1890 under section 2 restricts firms from engaging in anticompetitive conduct by utilising an individual firm's power to manipulate the market or partake in anticompetitive acts. A firm can be found in breach of the act if they have leveraged their market power to unfairly gain further market power in a manner that is detrimental to the market and consumers. The measurement of market power is key in determining a breach of the act and can be determined from multiple measurements as discussed in measurements of market power above. In Australia, consumer law allows for firms to have significant market power and utilise it, as long as it is determined to not have "the purpose, effect or likely effect of substantially lessening competition" ==Elasticity of demand==

The degree to which a firm can raise its price above marginal cost depends on the shape of the demand curve at a firm's profit maximising level of output. Consequently, the relationship between market power and the price elasticity of demand (PED) can be summarised by the equation: : \frac{P}{MC}=\frac{PED}{1+PED}. The ratio P/MC is always greater than 1 and the higher the P/MC ratio, the more market power the firm possesses. As PED increases in magnitude, the P/MC ratio approaches 1 and market power approaches zero. The equation is derived from the monopolist pricing rule: : \frac{P-MC}{P}=-\frac 1 {PED}. ==Nobel Memorial Prize==

Jean Tirole was awarded the 2014 Nobel Memorial Prize in Economic Sciences for his analysis of market power and economic regulation. ==See also==

• Syverson, Chad. 2019. "Macroeconomics and Market Power: Context, Implications, and Open Questions." Journal of Economic Perspectives 33(3): 23–43. • • The Theory of Industrial Organization, Tirole, MIT Press 1988 • Thomas Philippon. 2019. The Great Reversal: How America Gave Up on Free Markets. Harvard University Press.