Market power is defined as the ability of an organization to manipulate the price of a product or service in the market by influencing the demand and supply levels directly or indirectly. It is generally used in the context of keeping the price level a bit high than usual. Market power often results in the loss of economic welfare and minimized output.
Meaning of market power
Market power is often referred to as pricing power or economic strength because, in these conditions, the organization makes economic profit by exceeding both long-run average cost and marginal cost.
The organizations that possess market power can determine product or service prices by maintaining their market share. They easily increase the market price and that too profitably because these organizations do not lose the customers to competitors over the raised costs. This scenario where a company does not lose customers to the rival brand is referred to as price makers or price setters, whereas the firm that has no power over the market prices is known as price takers.
The firm with total market power can control either the total quantity that is being produced or the prices that are currently prevailing in the market. It is a fact that when a single firm or supplier starts controlling the market and influencing the costs, then it generally results in loss of economic growth.
When there is competition in the market, then the suppliers have to keep balanced and competitive prices because they fear the loss of customers to rival companies. In such scenarios, it is not so easy to manipulate prices until and unless every one of the suppliers decides to do so.
If raw material or a resource is not in an appropriate quantity, then the scarcity can play an essential role in the pricing power. We have seen that natural disasters have a direct impact on the produce of the crops and in such times the prices shoot up to unimaginable amounts.
For instance, in recent months the production of onions was affected because of bad weather, and this resulted in its price going up from Rs 20 to nearly Rs 150. The same story was seen the year before for pulses whose prices climbed up from almost Rs 100 to double the amount to reach Rs 200. This was because the scarcity and the narrow availability enabled some traders to control the prices and set them at such a high range.
Petroleum is one of the significant products that are significantly influenced by the external factors as scarcity as well as excessive usage keeps its prices fluctuating. This is why governments have set up bodies to keep a check on it.
Most countries have anti-trust bodies that keep a regular watch on the market prices and have created several methods to put a curb on the activities of the suppliers who try to influence market prices. There are legislations in place that has been created to curb the power of a single company in the market. The importance of such bodies is immense because it helps to bring down the prices once again. These governing bodies controlled the prices of pulses and onions referred to in the above example.
Understanding market power
The extent to which a commercial organization can influence market prices is market power. It has a direct impact on the bottom line of the financial statement because it results in high-profit margins. Remember, market power is equal to a high-profit margin, but the high-profit margin is not the same to market power because the profits can be the result of other factors also.
In some cases of market power, government approval becomes an important consideration, especially during mergers. This is because the government will not give its consent to a company if it believes that the change in ownership or the merger would result in a monopoly. This would automatically provide a viable power to the new company.
Sources of market power
The existence of market power can be attributed to anyone or a combination of more than one of the following sources
- Economies of scale
- Economies of scope
- Government regulation
- Intellectual property patent
- Product differentiation
- Intellectual property copyright
Factors influencing market power
The factors that can affect market power are as follows-
- Several companies in a market – Market power is inversely related to the number of organizations that are present in the market. The more the number of companies the less is the market power, and this is why the industry must not have too many participants if it wants to hold extensive power
- Ability to make an above-average profit – In a perfect competition it is not possible to make above-normal profits as both sellers and buyers are price takers. In case a company can make a profit above the normal range, then more players will join the field, and this will bring down the benefits to normal. It is only possible for a company with significant market power to make above the average profit
- Product differentiation – Differentiated products or services that can fulfill an essential need in the market will help the firm to influence market power. If a substitute product or service is available for critical products, then the market power is less
- Pricing power –high pricing power assist an organization in achieving market power. This is possible by offering exceptional or distinguished services or products that can help it to hold into large market share and meet inelastic demand from customers.
- The elasticity of demand – Elasticity of demand refers to the situation when the demand for a product remains consistent in spite of the changes in the product price. When there is inelastic demand from the customers, then a company can exert considerable market power. This is possible by offering unique services and products that create value for the customers
- Perfect information –In industries where the flow of information is perfect and is easily available to all the participants then it is not possible to achieve market power
- Factors mobility – The market power of individual firms will be less if the access to its inputs is equal for all interested parties
- Barriers to entry or exit – When a typical industry has high barriers to entry, the participants hold more market power. The new entrants can’t enter and survive because of several factors like low pricing or less information
Market power and market structure
The organization can exercise control over the market prices in various types of the economic systems. For instance, is the economy working under perfect competition, monopolistic competition, oligopoly or monopoly? The effect varies in different market structures hence let’s take a look at all of them to understand the concept better
1) Perfect competition
In a perfectly competitive market, the participants do not have any market power. All the players have a level field with zero power, and they have to remain satisfied with the market price that exists because it is not possible to manipulate the prices in these conditions. A perfectly competitive market is generally often considered an open market where you will find competition at its highest possible level.
The organizations sell a product or service to make a normal profit. Firms generally do not have to spend extraordinary sums on advertisement because there is perfect knowledge about it to interested parties. Some good examples of perfect completion markets are internet-related industries, agricultural markets, and foreign exchange markets.
Some key characteristics of a perfect completion market structure are
- There are free flow and availability of knowledge to all the participants in a market. This limits the role and risk-taking ability of the entrepreneur/supplier
- There are no barriers to exit or entry in such market
- Organizations often manufacture and produce an identical homogeneous unit of output
- Even the unit of input for instance labor is also homogeneous
- The need for government regulation is very less
- One firm can’t influence the market price
The benefits of perfect competition are as follows-
- Information is shared freely
- No barriers to entry
- Normal profits
- Limited or no advertising cost
- Maximum productive and allocative efficiency
When there is a single supplier in the market, it is defined as a pure monopoly market structure. Some examples of monopoly are water, telephone and electricity services. There are only a few instances where you will find pure monopoly, and in some cases, the power can also exist when there is more than one firm. The monopoly can be because of certain conditions for instance-
- If an organization has full or exclusive use or ownership of a resource that is scarce and not available easily then the market is said to be operating under monopoly structure
- When two or more organizations merge so that they can occupy the dominant position in the market
- If it is the government that grants a firm the status of monopoly, for instance, the post office
- If an organization has a copyright or patent for a product that gives them exclusive rights to it
The monopoly power can be maintained by setting up barriers for new entrants who try to challenge their claim.
It is possible via the following steps-
- The best way to deter new entrants is by economies of large scale production which will provide a cost advantage over the potential entrants
- Another way a company can maintain its monopoly stature is by dropping prices shallow and putting pressure on potential rivals who will not be able to handle it for long
- The organization can set its product prices just below the average cost. The new entrants cannot meet it at the onset because they will automatically go in red
- High set-up costs and greater sunk-costs are both barriers for new entrants
- The best way to maintain monopoly power is by having perpetual ownership of the sparse product
The cost of monopoly is as follows
- Monopoly is one of the reasons for the high prices of some products
- The consumer has either no or very less choice
- The output is restricted
- There is a loss of consumer surplus
- The monopolist has more information and uses it to exploit a consumer
- There is allocative and productive inefficiency in the market
This type of market structure exists when a few firms dominate the conditions with barriers to entry. They have shared power in the market, and some of its examples include cellular telephone, gas, aluminum and steel industries. The key characteristics of oligopoly market are as follows-
- Organizations in an oligopoly market are interdependent of each other. Every one of them has to take into account the reaction of its competitors to make its own decision.
- In an oligopoly market the participants have to take important decisions like whether they should cooperate or compete with competitors, should they implement a new strategy and whether they should lower or raise the prices of their products.
The natural barriers to entry in an oligopoly market are
- Economies of large scale production
- High set up costs
- High R&D costs
- Ownership of a scarce resource
The artificial barriers to entry in an oligopoly market are as follows
- The selling price is set at below the average value, and for new entrants, it is not possible to make profits
- The existing firms set the prices at such a low point that new entrants cannot make do
- Superior knowledge about the market and customers is utilized for personal benefit by an organization, and it deters new entry from stepping in the market
- A reliable brand name has earned the loyalty of its customers and prevents entry
- Exclusive copyright, license, and patents make it difficult for other entrances to enter the market
The advantages of oligopoly market are as follows
- Oligopoly market can adopt a competitive strategy to generate similar benefits like low prices to other market structure
- The dynamic efficiency of an oligopoly market can be seen in process development and new products
- The oligopoly market displays price stability that is beneficial for the consumers
The disadvantages of an oligopoly market are as follows
- The consumer choice is reduced because of high concentration
- The completion is less, and this reduces output and results in high prices
- Deliberate barriers of entry limits entry of new entrants
- The oligopoly market is productive and allocative inefficient
4) Monopolistic Competition
In monopolistic competition, several organizations sell their differentiated products in the same industry. The power is shared, and the firms can raise prices without losing customers. The critical characteristics of monopolistic competition are as follows-
- All the participants make independent decisions about output and pay based on their production costs, market, and product
- Knowledge is widespread but not perfect
- There is an increased risk involved in the decision-making
- There are no barriers to exit or entry into the market
- Firms are engaged in fierce advertising tactics to attract customers
The examples of monopolistic competition are as follows
- Consumer services
The advantages of monopolistic competition are as follows
- Monopolistic competition market is contestable as there are no barriers to entry
- The differentiation of products in a monopolistic market creates utility, choice, and diversity
The disadvantages of monopolistic competition are as follows
- The distinction of products often generates unnecessary waste
- Allocative inefficiency in both short-term and long-term
Abuse of market power
It is the dominant participants in a market that can abuse it, and this is why it becomes essential to have regulations in place that can control prices and quality of products or services.
Market power can result in abuse of market conditions, and this can lead to
- Raised prices of products or services even above competitive levels
- It stifles consumer demand because every one of them cannot afford the high prices
- Is harmful and not in the interest of common public
- Offering less or no choice to the consumer depending upon the market structure
- Generates efficiency losses
- Inefficient allocation of resources
- Some organizations implement strategies to reduce and restrict competition because they want to enhance their position in the market.
This is why a sound approach is needed to assess the dominance of participants and measure competition in an effective manner. There are sector regulators in place that have numerous tools and indicators at their disposal to identify market dominance. Some of them are as follows-
1) Market share observations
An organization with a significant market share occupies a dominant position in the market and has the capability to manipulate and influence prices. Market share and market power are interlinked to some degree, but the high percentage is not the only criterion to establish the dominance of market power.
The regulators have set up several thresholds to understand and identify when a market share should be a concern, and when it can result in serious power issues. Production capacities like capital and labor, value sales, and volume sales provide useful links in methods of measuring market share and the criteria to be used dependent upon the characteristics of the relevant market.
The European Commission has set some standards to assess dominance. As per its rules, an organization with a 25% market share does not hold a dominant position, one with 40% raise concern and ones that are over 50% are surely in a commanding position if its market share has remained stable for a long time.
2) Price level observations
When there is a continued increase in the level of prices, it can be a sign of market power. The regulator should be vigilant about the sustained growth but also remember that the high cost can be connected to an increase in cost-recovery tariffs.
3) Collusive activities
The regulators have to be very diligent and keep an eye on the firms that cooperate with others to limit competition. These are the organizations that are capable of dividing markets by fixing prices
4) Analysis of the strength of an organization
The European Commission has several factors to assess market dominance by an organization like control of infrastructure, the overall size of the firm, absence of purchasing power, technological advantages, access to financial resources, economies of scale, vertical integration, economies of scope and product diversification to name a few.
5) Analysis of barriers to entry
Barriers to entry happen because of high sunk costs or because of restricted access to essential facilities. Analysis of barriers to entry will show market dominance to the regulators
6) Quantitative measures
Several Quantitative measures can help to determine market dominance by an organization. Herfindahl-Hirschman Index (HHI)2 is an index that tells about the number of organizations in a market and also about their share in that market.
It is an indicator of the completion within a specific sector and is widely applied in competition law, antitrust and technology management. Another index Lerner Index also measures market dominance. It tells about the degree to which the price has exceeded the marginal
It is a fact that there should not be an overreliance on any one factor as it could lean towards biased policy decisions. It is better to use a combination of factors to assess market dominance to avoid probable pitfalls.