Market power

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It is said that a company has market power when it can increase and maintain the price of its products or services above the level that would exist in a perfectly competitive market.

Due to the increase in price, the demand may be reduced. Therefore, market power can lead to a reduction in the quantity produced (and sold). This implies a reduction in the welfare of society.

Degrees of market power

Companies can have different levels of market power. The most extreme case is the monopoly, which has total control over the price of its product since it is the only supplier.

However, there are intermediate degrees (between perfect competition monopoly) where companies have market power because they sell differentiated products, but they also face competition from other firms.

How is market power measured?

There is no universally accepted methodology. One of the approaches that has been suggested is to use the so-called Lerner Index, which measures the difference between price and marginal cost. However, having the information on marginal costs is very difficult so the measure cannot be easily used in practice.

As an alternative solution, instead of using marginal cost, some have proposed using moving average cost. Another alternative measure is the price elasticity of demand faced by the company, since it gives some signals about its ability to increase the price above the marginal cost. However, estimating elasticity requires a lot of information that is often not available.

Factors that facilitate the existence of market power

There are several factors that give a company such power:

  • Barriers to entry: It is difficult for new companies to enter the market to compete.
  • Differentiation: The products that companies offer are different in the eyes of the consumer.
  • Economies of scale: The cost of production falls as the quantity produced increases.

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