4.2 Market Power

[4.3 Pricing with Market Power [4.4 Pricing Strategies

[4.5 Pricing in Competitive Markets [4.6 Entry and Exit]

 

This topic introduces the concept of market power, describes why firms in the same industry might have different degrees of market power, and notes factors that determine a firm's market power.

 

Why are the prices of generic brand products significantly lower than the prices of name brand products in some markets, but very close in other markets? Does a firm decide on prices for its products or does the market decide for it? You can answer these questions in part using the concept of market power.

 

The more market power a firm has, the more easily it can set the prices of its products and influence the prices in its overall market.

 


Price-Setting Behaviour and Market Power

A firm in an industry is said to have market power (or to be a price-setter) if, by varying its price, it can vary the quantity demanded for its product. The more market power a firm has, the less effect an increase in price will have on quantity demanded.

 

For example, imagine two soft drink companies, one a premium brand with high customer loyalty and brand recognition (Citrus Attack), the other an economy product (Rolla Cola). Consider Citrus Attack's demand curve, shown below. Note that if Citrus Attack raises the price of its two-litre bottle from $1.20 to $1.40, quantity demanded will decline from 12,000 bottles to 10,000 bottles per week.

 

Now, consider the demand curve for Rolla Cola. If Rolla Cola makes a similar price change, from $0.80 to $1, quantity demanded is cut in half, declining dramatically from 1,000 to 500. Both firms are able to engage in price-setting behaviour, but the difference in the outcomes can be attributed to Citrus Attack's superior market power. The relative market power of the two firms is represented by the difference in the slopes of their demand curves. The steeper the negative slope, the greater the price inelasticity that the firm enjoys, and thus the greater its market power.

 

 

 

 

Price-Setters

One characteristic of having market power is that a firm can set the price of its products above its MC of production.

 

General Motors and Ford in the auto industry, General Mills and Kellogg's in the breakfast cereal industry, and IBM and Dell in the computer hardware industry are all examples of firms with such power. However, not all firms can raise prices above MC by the same amount. The degree of price markup over MC will depend on many factors such as

 

        elasticity of market demand

        number of firms in the industry

        degree of product differentiation

        the nature of the competition

 

A special case is that of a monopoly . Some examples include a utility company (eg, gas, electric or water) servicing a region or city, a cable company providing consumers access to television channels, or a metropolitan transport authority that owns the subway and bus services connecting various parts of the metropolis to each other and to the suburbs. In each of the above cases, because there is only one firm that provides the product or service to all consumers, it enjoys considerable market power.

 

Price-Takers

Not all firms or industries support price-setting behaviour. Consider for example the market for corn. Corn is a product, which means that consumers perceive brands of corn as being nearly identical. Moreover, the output of any single corn grower is very small relative to world supply. Because of this, individual growers have no control over the price they can charge. The market price is determined by the market supply and demand. With price thus established, each producer is a price taker or someone one who takes the market price as given.

 

The producer's output is insignificant relative to total output, therefore the producer cannot influence the market price by increasing or decreasing the individual supply of corn. For instance, suppose the prevailing US wholesale price for corn is US$12 per bushel. If a single corn grower attempts to charge a price higher than $12 per bushel, he or she will not sell any corn because buyers will simply purchase their corn from other growers. In other words, individual firms with no market power will face a horizontal demand curve, as in the figure below.

 

 

We will examine competitive markets where firms face this type of demand in topic 4.5.

 

Differences in Market Power

Market power varies from firm to firm, even within the same industry. In general, the less elastic a firm's demand, the more market power it will have. Why is this the case? Elastic demand implies a greater number of close substitutes for a firm's product. If elasticity is very high, firms are unable to charge much above the MCs of production because they know consumers will quickly switch to substitute goods. On the other hand, low elasticity of demand implies that consumers have limited alternatives and will be more likely to continue buying despite an increase in price.

 

The difference in market power between firms can be seen from the slope of their firm demand curves. In general, the steeper, more inelastic, the firm's demand curve, the greater the market power enjoyed by the firm. To see why, consider the figure below. In Demand Curve 2, the firm's demand curve is relatively flat, suggesting that consumers are very sensitive to changes in price and so have very elastic demand. A small increase in price from A to B results in a decrease in quantity of Q1 Ė Q2. In contrast, Demand Curve 1 is much steeper, reflecting more inelastic demand. The firm with Demand Curve 1 would have to increase its price from A to C to achieve the same decline in demand of Q1 Ė Q2. Thus, you can see that with a steeper, more inelastic demand curve, a greater price increase yields the same decrease in quantity.

 

 

 

To see the effects of market power in action, you can compare demand curves from four different industries (see below). Graph A illustrates the market demand for natural gas. In this case, natural gas is provided by a utility firm that has a monopoly. The residual demand curve for the utility coincides with the market demand. Demand for natural gas is highly inelastic and the utility company enjoys substantial market power.

 

 

 

Graph B shows the market demand for crude oil. The production of crude oil is dominated by the Organization of Petroleum Exporting Countries (OPEC), an organisation of oil-producing countries that have agreed to jointly determine their total supply of crude oil to the world market. OPEC can be viewed as one large producer of crude oil. Not all oil-producing countries are members of OPEC and the residual demand curve for crude oil faced by OPEC is distinct from the market demand curve. Consumers can substitute purchases of crude oil from OPEC with that from non-OPEC countries, making the residual demand curve for OPEC flatter (or more elastic) than the market demand curve. Although OPEC has considerable market power, it has less than the potential market power it could enjoy if all oil-producing countries belonged to OPEC.

 

In Graph C, the market demand for sport utility vehicles (SUVs) is plotted against the residual demand for an individual producer such as Toyota. In this case the residual demand is quite elastic, reflecting the fact that Toyota has many competitors in the SUV arena and that all producers compete aggressively for consumers. Although Toyota has market power, it is limited by the number of substitutes available and the competition among the firms.

 

Graph D shows the market demand for corn. Each producer of corn is small relative to the total market. Given the large number of producers, and therefore substitutes, that are available in the market, the residual demand curve for an individual producer is horizontal. It reflects the fact that the producer cannot vary prices at all by changing output. In this case, each producer has no market power.

 

 


Determinants of Market Power

What factors affect a firmís market power? A firm's market power will depend on the buyersí sensitivity to price , or the firm's elasticity  of demand. A firmís elasticity, and therefore its market power, will depend on the elasticity of market demand, the number of firms, degree of product differentiation and the interaction between firms.

Elasticity of market demand

The elasticity of demand for the firmís demand curve will always be more elastic than the elasticity of market demand. This is primarily because there are fewer substitutes for a product at the market level than at the firm level. For example, the demand for the Honda Accord will be more elastic than that for the total market for automobiles. Consumers will be much more sensitive to price changes in the Honda Accord than they will be to changes in the average price of cars. If the price of the Honda Accord increases by 10 percent, consumers will switch to competing vehicles such as the Ford Taurus or Toyota Camry, but if the prices of all cars increase by 10 percent, demand will fall less, relatively because of lack of competing products.

 

If market elasticity is high, the elasticity of demand for the firmís product will also be high and consequently market power will be low. As an example, consider the market demand for SUVs. Because of the ready availability of substitutes for SUVs, such as cars, pickup trucks and minivans, the market elasticity of demand for SUVs is relatively elastic. Since the demand for any one product within a market will always be at least as elastic as the market demand, the demand for a particular brand of SUV (such as the Ford Explorer) will be elastic as well.

Number of firms

As the number of firms in an industry increases, the availability of substitutes increases. Any firm in the market finds it harder to push prices above MC because of the possibility of losing customers to the rival firms. Market power is therefore lower in an industry with a larger number of firms.

 

The presence or absence of barriers to entry helps determine the number of firms in a market. The number of firms in an industry may be small because only few firms have exclusive control over the inputs required to manufacture the product or a patent on the technology needed for production.

 

For example, for a long period of time, the Aluminum Company of America controlled virtually every source of bauxite (an important input in aluminium production) and held patents on production processes used to make aluminium. It had a monopoly in the aluminium industry. Similarly, many high-tech companies try to obtain patents on their intellectual property to prevent entry into their markets.

 

The number of firms in an industry may also be small because, with economies of scale, few firms can supply the entire market at low cost. An example would be natural monopolies like utilities: in these industries it is too costly for more than one firm to supply the entire market. Market power would be high in such cases, causing the government to regulate pricing.

 

For some markets, the existence of well-known brands creates a barrier-to-entry. For instance, the existence of well-known brands in the cola market makes entry prohibitively costly. The cost of creating a nationally known brand to compete with well-established incumbents Pepsi and Coca-Cola has effectively prevented successful national entry into the cola market for many years.

 

For markets in which barriers-to-entry are low and where there are many competitors, market power is very low. For instance, entry barriers for the production of agricultural products are relatively low. The number of firms in such a market is very high, and each firm has correspondingly little market power.

Degree of product differentiation

Suppose a firm sells a product that is highly differentiated from competing products. This may be because consumers are loyal to the firm's brand or that the firm's product offers features not available in competing brands. The firm's demand tends to be inelastic because there are few close substitutes. In such a case, market power tends to be high.

 

An example would be the automobile industry, in which each firm tries to differentiate its product significantly from those of its competitors by spending money on advertising. The more successfully a commodity can be differentiated, the higher the market power of the firm that produces it.

 

Products can be highly differentiated simply because of customer perceptions. Even when one firm's products are identical to a generic brand, for example, the firm will have high market power if customers perceive the two products as different (perhaps as a result of advertising).

Interaction among firms

The nature of interaction among firms is also an important determinant of market power. If firms interact collusively to set prices, then they will be able to maintain high prices and market power will be high. The case of OPEC in the oil industry would be an example of such behaviour.

 

On the other hand, if firms compete aggressively by undercutting the price of rival firms, then market power will be low. The airline industry, in which price wars are relatively common, would be an example of this.

 

Click on the link here for an example of determining market power.

 


Topic Summary

  • A firmís market power is related to the relative price elasticity of the demand for its product.

  • A firm has more market power if its demand is less price elastic.

  • In a monopoly, the firmís demand curve is the same as market demand curve and has the same price elasticity.

  • In perfect competition, the firmís demand curve is different from the market demand curve and is perfectly price elastic (or horizontal).

  • A firmís market power is determined by the elasticity of market demand, the number of firms, degree of product differentiation, and the interaction amongst firms.

You may now proceed to topic 4.3, "Pricing with Market Power".