Market power

Market power is the ability of a firm to profitably raise prices above competitive levels by restricting output, reflecting the degree to which a firm can influence market prices rather than taking them as given (Carlton D.W., Perloff J.M. 2015, p.93)^[1]. In a perfectly competitive market, firms are price takers—they accept the market price or sell nothing. With market power, firms become price makers. They can raise prices and still find buyers, though at reduced quantities. The more inelastic the demand, the greater the power.

Market power matters for efficiency, equity, and policy. Firms with market power produce less and charge more than competitive firms would, creating deadweight losses. They transfer wealth from consumers to shareholders. Antitrust law exists largely to constrain the acquisition and abuse of market power. The Sherman Act of 1890 and subsequent legislation reflect societal concerns about concentrated economic power.

Sources of market power

Several factors create pricing power:

Barriers to entry

Economies of scale. When efficient production requires large scale, new entrants face a choice: enter small and be inefficient, or enter large and risk oversupplying the market. Either way, incumbents are protected^[2].

Capital requirements. Industries requiring massive upfront investment (semiconductors, aircraft, utilities) deter entry. Few firms can raise billions to build a new chip foundry.

Regulatory barriers. Licenses, permits, patents, and regulations can limit entry. Pharmaceutical patents grant temporary monopolies. Broadcasting licenses restrict spectrum access.

Network effects. When product value increases with user numbers, early leaders gain advantages that compound. Social networks, payment systems, and operating systems exhibit strong network effects.

Product differentiation

Brand loyalty. Strong brands command premium prices because customers perceive switching costs. Coca-Cola's market power stems partly from brand value that competitors can't easily replicate^[3].

Switching costs. When changing products is costly—learning new software, transferring data, breaking contracts—customers tolerate higher prices rather than switch.

Location. Geographic differentiation creates local market power. The only gas station for fifty miles has pricing power regardless of how competitive urban markets are.

Control of essential inputs

Raw materials. Controlling scarce resources confers power. De Beers long controlled diamond distribution; OPEC coordinates oil supply.

Intellectual property. Patents, copyrights, and trade secrets prevent imitation, sustaining differentiation and pricing power.

Measuring market power

Economists assess market power through:

Lerner Index

Price-cost margin. The Lerner Index equals (Price - Marginal Cost) / Price. Under perfect competition, price equals marginal cost, so the index is zero. Monopolists with inelastic demand have indices approaching one^[4].

Interpretation. Higher indices indicate greater market power. A Lerner Index of 0.5 means price is twice marginal cost.

Practical challenges. Marginal cost is difficult to observe directly, limiting practical application.

Concentration ratios

Market share measures. The four-firm concentration ratio (CR4) sums the market shares of the four largest firms. CR4 above 60% often indicates concentrated markets.

Herfindahl-Hirschman Index. HHI sums squared market shares. Values above 2,500 indicate highly concentrated markets according to DOJ/FTC guidelines.

Limitations. Concentration doesn't automatically mean market power—contestable markets may be concentrated but competitive^[5].

Market structures

Power varies by structure:

Monopoly

Single seller. A monopolist is the sole supplier, facing the entire market demand curve. Maximum market power—limited only by demand elasticity and threat of entry.

Pure monopoly. Rare in practice. Even apparent monopolists face substitute competition. Microsoft dominated PCs but competed with gaming consoles, tablets, and now cloud services.

Oligopoly

Few sellers. A small number of firms dominate, each large enough to affect market prices. Airlines, automobiles, telecommunications—classic oligopolies.

Strategic interdependence. Oligopolists consider rivals' reactions when setting prices. This game-theoretic dimension distinguishes oligopoly from other structures^[6].

Collusion temptation. With few firms, coordination (explicit or tacit) becomes feasible. Cartels like OPEC exercise collective market power.

Monopolistic competition

Many sellers, differentiated products. Each firm has slight market power from product differentiation, but faces many competitors. Restaurants, clothing retailers, personal services.

Limited power. Entry is relatively easy, constraining pricing power. Long-run economic profits are competed away.

Antitrust implications

Market power attracts regulatory attention:

Sherman Act

Section 2. Prohibits monopolization and attempts to monopolize. Having monopoly power isn't illegal—acquiring or maintaining it through anticompetitive conduct is^[7].

Conduct standards. Courts examine whether dominant firms use exclusionary practices—predatory pricing, exclusive dealing, tying arrangements—to maintain power.

Merger review

Competitive effects. Mergers that substantially lessen competition or tend to create monopoly face challenge. HHI increases guide enforcement decisions.

Efficiencies defense. Mergers creating efficiencies may be approved despite concentration increases if benefits pass to consumers.

Recent developments

Tech platforms. Digital platforms raise new market power concerns. Network effects, data advantages, and ecosystem control create durable power that traditional antitrust tools may inadequately address^[8].

Global coordination. Cross-border firms require international enforcement coordination. US, EU, and national authorities increasingly cooperate.

Welfare effects

Market power affects economic welfare:

Allocative inefficiency. Prices above marginal cost mean consumers who value goods above cost don't purchase—deadweight loss.

Productive inefficiency. Without competitive pressure, firms may not minimize costs—X-inefficiency.

Dynamic effects. Market power may fund innovation (positive) or reduce innovation incentives (negative). Schumpeter argued monopoly profits fund R&D; Arrow argued competitive pressure drives innovation.

Distributional effects. Market power transfers surplus from consumers to producers, raising equity concerns.

Market power — recommended articles

Microeconomics — Competition — Monopoly — Antitrust

References

• Carlton D.W., Perloff J.M. (2015), Modern Industrial Organization, 4th Edition, Pearson.
• Motta M. (2004), Competition Policy: Theory and Practice, Cambridge University Press.
• DOJ (2023), Antitrust Division, Department of Justice.
• Tirole J. (1988), The Theory of Industrial Organization, MIT Press.

Footnotes

1. ↑ Carlton D.W., Perloff J.M. (2015), Modern Industrial Organization, p.93
2. ↑ Motta M. (2004), Competition Policy, pp.67-89
3. ↑ Tirole J. (1988), Theory of Industrial Organization, pp.134-156
4. ↑ Carlton D.W., Perloff J.M. (2015), Modern Industrial Organization, pp.112-124
5. ↑ DOJ (2023), Horizontal Merger Guidelines
6. ↑ Tirole J. (1988), Theory of Industrial Organization, pp.178-192
7. ↑ Motta M. (2004), Competition Policy, pp.112-134
8. ↑ Carlton D.W., Perloff J.M. (2015), Modern Industrial Organization, pp.234-256

Author: Sławomir Wawak