Explain the sources of market power.

Intro

  • Market power is a firm’s ability to influence the market price without losing all of its sales volume.
  • It depends on the degree of closeness of substitutes of competitors’ products and the number of competing firms in the market.
  •  This in turn depends on the extent of differentiation of the product and the level of entry barriers.

Body

  • Product differentiation
  • The degree of closeness of available substitutes determines a firm’s market power. If there are many firms due to low entry barriers, but each firm is able to differentiate its product such that its consumers perceive the products of its competitors to be imperfect substitutes, the firm will possess some market power. E.g. monopolistic competitive firm like a restaurant business.
  • The greater the degree of product differentiation, the higher is the firm’s market power.
  • Product differences can be real (achieved via innovation) or imaginary (achieved via persuasive advertising)
  • When large sums of money are involved in creating these differences (e.g. branding via advertisements) or when patents are obtained to sustain the product differentiation, market power is preserved because these methods of product differentiation create entry barriers. This idea is developed below.
  • Entry barriers
  • A barrier to entry refers to any obstacle placed by incumbent firms or disadvantage faced by potential competitors which restricts or prevent them from competing with established firms in the market.
  • The fewer the number of firms in the market, the fewer the number of substitutes that consumers can turn to when a firm raises its price. Thus, the higher is the firm’s market power.
  • Types of entry barriers

Artificial

Artificial barriers are created by existing firms or the government, to limit the entry of new firms.

  • Intellectual property rights

E.g. Patents

  • To promote inventions (e.g. improved pharmaceutical drugs) governments may issue patents. A patent grants an inventor the exclusive rights to produce/sell the product or use the production process that is patented for a limited period of time. The aim of patents is to help the inventor to at least recoup its costs of R&D. However, the effect is that competition is limited since new firms who do not have the right to use the knowledge needed for producing the good will be unable to enter the market.
  •  Trade barriers

Governments may impose tariffs / quotas on certain imports to reduce foreign competition and so increase the market power of domestic firms in those industries. (e.g. rice in Japan)

Natural

  • Natural barriers are ‘natural’ in the sense that they are inevitable in a particular market or industry.
  • High startup cost
    • Applicable to industries that need an extensive distribution network which is costly — pipes, cables (e.g. utilities, cable TV, rail travel), or has high initial capital outlay (e.g. airlines, airport service, mobile telecommunication service).  New firms are deterred from entering such industries due to lack of ability or willingness to incur the huge costs.
  • Economies of scale (EOS)
  • This refers to decreases in unit costs with increases in output level.
  • When the production process provides a lot of scope for technical EOS (e.g. car manufacturing), the incumbent firms tend to grow to a large size to enjoy the cost savings (if the market demand allows it) and acquire cost advantage over potential new entrants.
  • EOS enables incumbent firms to practice limit pricing to deter the entrance of new firms. I.e. exploit EOS and charge a low price that is not profit maximising (but sufficient for it to earn at least normal profits) such that new firms find hard to match.
    • When the MES is high relative to market demand, which tends to be so for industries with extremely high startup costs => only 1 or a few firms can produce profitably. When only 1 firm can produce profitably, the industry is a natural monopoly.
  • Geographical distance

Vast geographical distances keep markets in different locations separated from each other. This limits the extent of competition in each market. Reason: The high cost incurred in transporting goods between markets makes it unprofitable for firms to expand beyond their existing markets. The high costs incurred in travelling between markets discourages consumers from sourcing for cheaper alternatives in other markets despite the high prices they are charged.

Conclusion

The above entry barriers explain why some markets are either monopoly or oligopoly.