Market structure
In economics, 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 are relative to the market structure that the firms operate in. There are four main forms of market structures that are observed: perfect competition, monopolistic competition, oligopoly, andPerfect competition power
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 aMonopoly 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 aOligopoly 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 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. 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. It is important to note that 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 There are several sources of market power including: # High barriers to entry. These barriers include the control of scarce resources, increasing returns to scale, technological superiority and government created barriers to entry.Krugman & Wells, Microeconomics 2d ed. (Worth 2009) 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. # High start-up costs. This barrier makes it difficult for new entrants to succeed as the initial creation costs are ingrained within the industry. Firms like power, cable television and telecommunication companies fall within this category. A firm seeking to enter such industries require the ability to spend millions of dollars before starting operations and generating revenue. # Brand loyalty of consumers and value placed by consumers on reputation. Incumbent firms often have a competitive advantage over new entrants as customers are familiar with the product and service. An incumbent firm can engage in several entry-deterring strategies such as limit pricing, predatory pricing and strategic bundling. Microsoft has substantial pricing or market power due to technological superiority in its design and production processes. # Government policies/regulations. 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.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 mark-up or margin. The higher a firm's mark-up, 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 rations are the most frequently used measure of market power. Measures of concentration summarise the share of market or industry activity accounted for by large firms. An advantage of using concentration as an empirical tool to quantify market power is the requirement of only needing revenue data of firms which results in the corresponding disadvantage of the inconsideration of costs or profits.''N''-firm concentration ratio
The ''N''-firm concentration ratio gives the combined market share of the largest ''N'' firms in the market. For example, a 4-firm concentration ratio measures the total market share of the four largest firms in an industry. In order to calculate the ''N''-firm concentration ratio, one usually uses sales revenue to calculate market share, however, concentration ratios based on other measures such as production capacity may also be used. For a monopoly, the 4-firm concentration ratio is 100 per cent whilst for perfect competition, the ratio is zero. 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.Samuelson & Nordhaus, Microeconomics, 17th ed. (McGraw-Hill 2001) at 184. For example, in a market with two firms, each with 50% market share, the HHI equals = 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 index
The Lerner index is a widely accepted and applied method of estimating market power in a monopoly. It compares a firm's price of output with its associated marginal cost where marginal cost pricing is the "socially optimal level" achieved in market with perfect competition. 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: 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.Perloff, J: Microeconomics Theory & Applications with Calculus page 369. Pearson 2008. Consequently, the relationship between market power and the price elasticity of demand (PED) can be summarised by the equation: : 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: :Nobel Memorial Prize
Jean Tirole was awarded the 2014See also
* Bargaining power * Imperfect competition * Market concentration * Natural monopoly * Predatory pricing * Price discrimination * Dominance (economics)References
Further references
* Syverson, Chad. 2019.