Microeconomics 7

Market failure and socially undesirably outcomes III: Market power (HL only)

Introduction to Market Power

Market power refers to the ability of a firm or a group of firms to influence or control the price and output of a good or service in a market. Unlike in perfectly competitive markets, where no single firm can affect market prices, firms with market power can raise prices above competitive levels without losing all of their customers. Market power is a source of market failure because it leads to inefficiencies, higher prices for consumers, reduced output, and, in extreme cases, monopolistic behavior that harms societal welfare.

Sources of Market Power

Market power arises in imperfectly competitive markets, such as monopolies, oligopolies, and monopolistic competition. Several factors contribute to the emergence of market power, including:

Barriers to Entry: Firms with market power often benefit from high barriers to entry that prevent other firms from entering the market and competing. Barriers can include high startup costs, economies of scale, control over essential resources, or legal barriers like patents and licensing.
Product Differentiation: Firms that can differentiate their products from those of competitors through branding, quality, or other unique features can gain market power by creating customer loyalty and reducing the effectiveness of competition.
Control Over Essential Resources: Firms that control vital resources needed for production (such as raw materials or technology) can restrict access to these resources, giving them an advantage over potential competitors.

Market Power and Welfare Loss

When firms with market power raise prices above the competitive level, it leads to a reduction in consumer surplus and an increase in producer surplus, but the overall result is a net loss in societal welfare. This is referred to as allocative inefficiency, where the quantity of goods produced is lower than the socially optimal level. In a perfectly competitive market, prices reflect the true cost of production, and resources are allocated efficiently. However, with market power, firms can restrict output to maximize profits, leading to higher prices and underproduction.

This welfare loss is represented by deadweight loss, which is the loss of economic efficiency when the equilibrium outcome is not achieved. Consumers pay higher prices and consume less, while firms produce less than they would in a perfectly competitive market, resulting in a misallocation of resources.

Monopolies and Oligopolies

Monopolies: A monopoly exists when a single firm controls the entire market for a good or service. Monopolies have significant market power, allowing them to set prices well above marginal costs, which leads to allocative inefficiency and deadweight loss. Natural monopolies, which arise in industries with high fixed costs and economies of scale (such as utilities), are often regulated by the government to prevent excessive pricing.
Oligopolies: An oligopoly is a market structure dominated by a small number of large firms. Oligopolies can engage in collusion, where firms agree to limit competition by setting higher prices or controlling output. Collusion leads to outcomes similar to monopolies, where prices are higher and output is lower than in competitive markets. Tacit collusion, where firms implicitly agree to avoid price competition, is also common in oligopolistic markets.

Regulation of Market Power

Governments often intervene to regulate market power and mitigate its negative effects. Common regulatory actions include:

Antitrust Laws: Governments enforce antitrust laws to prevent monopolies and anti-competitive behavior, such as price-fixing and collusion. These laws promote competition and protect consumers from the negative effects of market power.
Price Regulation: In industries where monopolies or oligopolies are natural (such as utilities or public transportation), governments may impose price controls to prevent firms from charging excessively high prices. For example, governments may cap the prices that monopolistic firms can charge, ensuring that prices are closer to the competitive level.
Deregulation: In some cases, governments may reduce or eliminate regulations that create artificial barriers to entry, allowing more firms to enter the market and increasing competition. Deregulation can help reduce the market power of dominant firms by encouraging more firms to compete.

Conclusion

Market power is a significant source of market failure because it leads to inefficiencies, reduced output, and higher prices for consumers. Monopolies, oligopolies, and other forms of market power distort resource allocation and create welfare losses. Government intervention through antitrust laws, price controls, and regulation is often necessary to limit the negative effects of market power and promote competition. By regulating market power, governments can help ensure that markets function more efficiently and in the best interests of society.