Market Power

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Last Updated:December 5, 2023

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What is Market Power?

Market power is a measure of how much a company can influence the price of a product or service in a given market by manipulating supply and demand. The higher the market power (also known as pricing power), the more influence the firm has in the marketplace.

Firms with substantial market power can influence the market price, controlling their profit margins. They’re also able to create barriers to entry in the market, limiting the number of competitors to break through and challenge them.

Understanding Market Power

When firms have high pricing power, they’re considered to be price-makers. Essentially, they have enough market power to “make” or change the market price of the product or service.

When a firm lacks this influence, they’re considered to be price-takers. These firms must take the market price and sell at it. If they try to charge more for the product, they will lose out on business, revenues, and, ultimately, profits.

Marketplaces with lots of price-takers are going to be very competitive. They will often have lots of substitutes for the products being sold. This is great for consumers because they can buy the cheapest product, and it won’t be too different from a more expensive product.

This isn’t as good for producers because the profit margins will be thinner than if they were price-makers. The lack of influence and pricing power to sell at a higher price will lower potential revenues and profits.

Gaining pricing power always benefits firms that want to make large profits. Firms can use it to:

Charge higher prices than is necessary
Lower the quality of their products or services
Discriminate against certain customers
Artificially restrict supply in the market to keep costs high
Use their power to bully competitors out of the market
Price gouge during hard times

Factors influencing Market Power

Different factors influence the power a firm has in a market. Many of these factors correlate with the type of market the firm is in.

The factors that influence this power are:

1. Competitors in the market

If a firm holds a lot of influence within a marketplace, there can’t be too many firms rivaling and competing.

Pricing power has an inverse relationship with the number of companies in a market. Therefore, a market with fewer players will influence existing firms more.

2. Elasticity of demand

In order for a firm to gain substantial pricing power, there must be inelastic demand within the market. Inelastic demand means that there is a significant need for the product regardless of the price.

If firms want to make their demand more inelastic, they must provide unique products or services that competitors offer. The firm must try to separate the product from rivals to emphasize buying its product.

3. Product differentiation

Product differentiation can lead to a firm having more influence over prices because of the inelastic demand created by a lack of substitutes.

4. Firm’s ability to generate above “normal profit”

In a market where firms are price-takers, it will be impossible for firms to make above-normal profits in the long run.

This is because, in this market structure, if firms are making more than normal profit, more firms will try to join the market.

Normal profit is the minimum amount of profit a firm has to make to justify continuing operations.

In the long run, there will be so many firms in the market that no one is making a normal profit; they’re breaking even.

When a firm has high pricing power, they’re able to make above a normal profit because firms entering the market don’t hurt them as much. They have pricing power and can set the price of goods at whatever it pleases.

5. Pricing Power

When a firm has a large market share, and the market lacks competition, the firm, to an extent, can dictate the prices of the products it sells. Firms with substantial pricing power are able to garner high market power.

6. Perfect Information

If an industry has ample and perfect information available, consumers will be able to find the cheapest option when looking for products to buy. This makes it almost impossible for firms to achieve pricing power.

Information asymmetry, on the other hand, allows firms always to have more information than their consumers. Firms are able to charge higher prices and make more sales at these higher prices due to the lack of information available.

7. Barriers to entry (or exit)

When barriers to entry in a market are high, existing firms will have pricing power. High barriers to entry make the market harder to enter for new firms. This means that the market will lack competition, and there will be fewer substitutes for products.

Consumers will be forced to buy from an existing firm if they want the product, regardless of how high the price is.

8. Factor mobility

A firm’s pricing power will suffer if the industry provides equal ability to access the input of its goods and services.

Market Power in Different Market Concentrations

According to the market structure in which a firm competes, the type of power they hold will be different. In some markets, they will hold all the power. In others, they will hold little to no power. It all depends on the competition of the market structure and the other firms present.

The different market structures and their role in a firm’s power are:

1. Perfect Competition

In perfect competition, there are many sellers and many buyers. These sellers are selling identical products to their competitors.

The market also has little to no barriers to entry, so firms are able to enter and exit the market freely. Firms are not able to make above-normal profits in these conditions.

Demand will be highly elastic due to the ample amount of substitutes and information available to consumers. All firms in the market are considered to be price-takers and hold no market power.

2. Monopolistic Competition

Monopolistic competition is a more real-world example of a market structure. It's when there are a lot of firms within the market selling similar products, but each product is different in its own way. This means that there are no perfect substitutes.

Sellers are able to have more control over their pricing because consumers won’t be able to find the same product at a lower price from another company. Since firms are able to have some sort of pricing power, they will garner some degree of market power.

This pricing power won’t be as strong as, say, a monopoly or oligopoly because there is still a significant amount of competition and the demand isn’t highly inelastic. However, firms will have more pricing power than in perfect competition.

3. Oligopoly

Oligopolies are market structures where there are a few firms that control the entire market. These firms sell differentiated products but are still considered to be competitive with each other.

There are high barriers to entry in these markets, so the existing firms are going to keep most of the market share despite new firms trying to enter. The demand is relatively inelastic due to the lack of competition and substitutes.

In this market, a few firms will have pricing power. Their pricing power will be relatively high, allowing them to influence prices in the market.

4. Monopoly

In a monopoly, a single firm owns all of the market shares. This means that there are zero substitutes for the product, and there is no competition in the market.

The market has extremely high to absolute barriers to entry, making it nearly impossible for a firm to rival the existing monopoly.

The demand is as inelastic as it will get. Firms are able to charge whatever price they feel will maximize profits. Besides government regulation affecting these firms’ decisions, the firms have ultimate pricing power.

Monopolies have extremely high market power and control over the market.

Measurement of Market Power

Measuring it on a firm is tough. Most of the common metrics for pricing power are sensitive to the definition of a market and the range of analysis.

Measuring a firm’s pricing power is extremely important for managers and managerial economics. This is because it can be related to a sustainable advantage for a firm. It is also brought up in many antitrust lawsuits.

The size of a firm’s pricing power is displayed by its ability to deviate from an elastic demand curve and sell at a higher price than its marginal cost, leading to the firm making above-normal profits.

The higher the firm is able to grow its margins, the larger the magnitude of its market power is. Measuring markups is difficult due to their reliance on a firm’s marginal costs, so concentration ratios are more commonly used to measure pricing power.

Concentration ratios can be used for any firm, regardless of if they hold lots of pricing power or none.

Concentration ratios should be examined and used carefully. They’re imperfect measures of potential pricing power, and an overreliance on them can lead to biased policy decisions. This is what happened in the energy sector in the 1990s in the US.

Concentration Ratios

Market concentration (also known as industry concentration) is a measure used to show the extent to which market share is concentrated between a few firms in the market.

These high-power firms generate most of the economic activity in the market, measured through metrics like sales, employment, and active users. Concentration rates are the most frequently used measure of it.

Using concentration rates is exceedingly simple because the only piece of data you need is the revenue of each firm. This can also be a disadvantage because the metric won’t take into account the costs or profitability of the firm.

There are ultimately three common metrics that economists use to determine the pricing power of a firm:

1. N-firm concentration ratio

The N-firm concentration ratio displays the combined market share of the biggest N firms in the market.

For example, a 3-firm concentration ratio measures the total market share of the three biggest companies in the market.

To calculate the N-firm concentration ratio, you use the sales revenue to calculate the market share of the firm(s).

Although less common, one can also use other measures like production capacity. This would result in a different ratio than using revenue, but would still allow you to see the market power of a firm.

In the case of a monopoly, the 3-firm concentration ratio is 100%. On the other hand, in a perfectly competitive market, the ratio will be zero.

Throughout countless studies done by economists, it’s been determined that firms in an oligopoly market structure will have a concentration ratio between 40 and 70 percent.

2. Herfindahl-Hirschman index

The Herfindahl-Hirschman index is another measure of concentration. The measure is the sum of the squared market shares of every firm in the market.

For example, in a market with 4 firms, each firm has a market share of 25%. The HHI would equal

Σ = (Sٖᵢ)² = (0.25)² + (0.25)² + (0.25)² + (0.25)² = 0.25

Similar to the N-firm concentration ratio, the HHI of a monopoly would be 1, while the HHI of a perfectly competitive market would be zero.

In the Herfindahl-Hirschman index, larger firms are given more weight compared to smaller firms. The HHI thereby conveys more information than the N-firm concentration ratio.

The HHI is not perfect by all means and still has its weaknesses. The HHI is relatively sensitive to the definition of the market. This means that you can’t use it to compare across different industries or do analysis over time if the industry changes frequently.

The table below describes the relationship between the Herfindahl-Hirschman index and market structure. The greater the HHI value, the greater the market power of a firm.

Market Structure	Range of HHI
Perfect Competition	Generally below 0.2
Monopolistic Competition	Generally below 0.2
Oligopoly	0.2 to 0.6
Monopoly	0.6 and above

3. Lerner index

The Lerner index is used to estimate it in a monopoly. The measure compares a firm’s price of output with its corresponding marginal cost, where the marginal cost pricing is the “socially optimal level” achieved in a perfectly competitive market.

Lerner theorized that it is the monopoly’s ability to increase its prices above its marginal cost. This can be displayed by the formula:

L = (P - MC) / P

In this equation, P represents the price of the good that is set by the firm, while MC represents the firm’s marginal cost.