Market power is a measure of the economic strength of a firm. It is the ability of a firm to influence the quantity or price of goods and services in a market. A firm is said to have significant market power when price exceeds marginal cost and long run average cost, so the firm makes economic profits. Such firms are often referred to as "price makers. " In contrast, firms with limited to no market power are referred to as "price takers. "
Determinants of Market Power
A firm usually has market power by virtue of controlling a large portion of the market. However, market size alone is not the only indicator of market power. Other factors that affect a firm's market power include:
- Number of producers
- Size of firms in the market
The numbers and size of firms determine the extent that firms can withstand pressures and threats to change prices or product flows. However, being a large firm does not necessarily equal market power. For example, while conglomerates may be very large, they may play only small roles in many different markets and have no ability to influence prices in any of them.
- Barriers to entry
Barriers to entry determine how contestable the market is. Even highly concentrated markets may be contestable markets if there are no barriers to entry or exit, which limits a firm's ability to raise its price above competitive levels.
Common barriers to entry include control of a scarce resource, increasing returns to scale, technological superiority, and government-imposed barriers.
- Availability of substitute goods
Greater availability of substitute goods will weaken a firm's market power.
Relationship between Market Power and Firm Behavior
A firm's market power influences its behavior. For example, market power gives firms the ability to engage in unilateral anti-competitive behavior. Some of the behaviors that firms with market power are accused of engaging in include predatory pricing, product tying, and creation of overcapacity or other barriers to entry . If no individual participant in the market has significant market power, then anti-competitive behavior can take place only through collusion, or the exercise of a group of participants' collective market power.
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In 2012, the U.S. Federal Trade Commission opened an antitrust probe against Google's search practices. Google allegedly used its market dominance to promote its own products over competitors' products in web searches.
A monopoly, a price maker with market power, can raise prices and retain customers because the monopoly has no competitors. If a customer has no other place to go to obtain the goods or services, they either pay the increased price or do without.
An oligopoly may also be a price maker with market power, as firms may be able to collude and control the market price or quantity demanded.
A perfectly competitive firm, a price taker with no market power, cannot raise its price without losing its customers.
Measurement of Market Power
Measurement of market power is often accomplished with concentration ratios or the Herfindahl-Hirschman Index (HHI).
Concentration Ratios
The concentration ratio is the proportion of total industry output produced by the largest firms (usually the four largest). This measure of market power relates the size of firms to the size of the market. For monopolies, the four firm concentration ratio is 100 percent, while the ratio is zero for perfect competition.
Herfindahl-Hirschman Index (HHI)
The Herfindahl-Hirschman Index (HHI) is a measure of the size of firms in relation to the industry, and an indicator of the amount of competition among them. The HHI is calculated by summing the squares of the percentage market shares of all participants in the market. The HHI for perfect competition is zero; for a monopoly, it is 10,000.
For example, if a market consists of five firms with market shares of 40, 20, 20, 15, and 5 percent each, the HHI is 2650 (
Measurement Problems
The use of the concentration ratio or the HHI to measure market power is not perfect. A high concentration ratio or large firm size is not the only way to achieve market power. Many smaller firms acting in unison can achieve the same result. Additionally, the measurements do not convey the extent to which market power may be concentrated in a local market.