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The Economics of Market Power

An introduction to the analysis of market

power for King & Wood Mallesons

Dr Luke Wainscoat

Senior Economist, HoustonKemp

24 November 2015

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1. Market Power

2. Barriers to Entry

3. Competition from Existing Suppliers

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We all know competition when we see it

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Competition No competition

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• Features:

› Many firms – individual firms are ‘price takers’

› Many consumers – individual consumers are ‘price takers’

› Homogeneous goods

› No barriers to entry

• Outcomes:

› Price=average cost

› Zero economic profit (revenue=opportunity cost)

› Firms operate at efficient scale

› Price=Marginal revenue=Marginal cost

What is perfect competition?

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What is a monopoly?

• Features:

› A single firm which is a ‘price maker’

› The higher the price, the less it sells

› Barriers to entry prevent new suppliers entering

• In practice

› Monopoly licensing

› Natural monopoly

› Proprietary knowledge

protected by patent

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$

Quantity

Marginal

cost

Demand=marginal

revenue

Price (Perfect

competition)

Output (Perfect

competition)

Output is lower and prices are higher under a monopoly

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Two elements to a monopolist’s marginal revenue

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Monopoly increases

output by one unit

Quantity sold increases

Price Revenue

Output

Price falls

Loss of revenue

from lower price

on existing sales

Additional revenue

from one additional

saleRevenue

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Output is lower and prices are higher under a monopoly

88

$

Quantity

Marginal

cost

Output

(Monopoly)

Price

(Monopoly)

Demand

Marginal revenue

(monopoly)

Price (perfect

competition)

Output

(Perfect

competition)

Producer surplus

Consumer

surplus Dead weight loss

Richard A. Posner ‘the economic

theory of monopoly provides the only

sound basis for antitrust policy’

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Logic of monopoly applies to any firm with market

power

• Marginal revenue < price

• Firms produce and sell less than in a perfectly

competitive market

• There is deadweight loss / inefficiency

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But – some market power is good!

• Market power is the ‘reward’ for offering a better

product than competitors

• Cost of intervention

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Market power is the ability profitably to raise

prices above the competitive level

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Market

power

Absence of

competition

Absence of

competitive

constraints

Outcome not

consistent with

competition

Existing

firms

Potential

entrants

Customer

buyer

power

Profits Prices Output

Queensland Wire: ‘ability of a firm to

raise prices above the supply cost

without rivals taking away customers

in due time’

Melway: ‘capacity to act

unconstrained by the conduct

of competitors’

Boral: ‘absence of constraint

from the conduct of

competitors or customers’

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Evidence of market power

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Market

power

High profits and

margins

Market

power

High profits

and margins

• Many reasons for high profits

• Measuring profitability for economic analysis is very

difficult

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1. Market Power

2. Barriers to Entry

3. Competition from Existing Suppliers

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A single supplier can be perfectly competitive

• Perfectly contestable market

› One supplier

› Technology/knowhow for production

available to all

› Fixed, but no sunk costs

• Outcome

› Price=average costs

• But

› Fixed costs often sunk – no

‘hit and run’ entry

› New entrants may have higher

variable costs

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Barriers to entry allow incumbents to set prices above

the competitive level without entry occurring

• Some disagreement on exact definition

• Something that allows the incumbents to earn above-normal

profits

• A cost of producing that must be borne by an entrant but not

incumbents

• Additional profit earned as a sole consequence of being

established in the industry

• Barriers to entry allow firms to have market power

• Extent to which the threat of entry restricts market

power depends upon:

› Likelihood of entry

› Timeliness of entry

› Impact of entry on the incumbents

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There are three types of entry barriers

• Structural

› Economies of scale

› Sunk costs

• Strategic

• Legal/regulatory

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Evidence

• History of entry and exit

› Lots of entry=low barriers

› But, low entry does not imply high barriers

• Would timely entry occur if prices rose above

competitive levels?

› What does new entrant need to do?

› Sunk costs of entry

› Variable costs of new entrants?

› Profitability of entry

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1. Market Power

2. Barriers to Entry

3. Competition from Existing Suppliers

Comparing the two most common forms of

competition used

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Price is above the perfectly competitive level

when firms decide what quantity to produce

• Firms independently and simultaneously decide their

own quantity/capacities

• Products are homogeneous

• Prices determined by total amount supplied by all

firms

• Examples:

› Airlines

› Farms

› Mining

• Equilibrium

› Firms choose quantity such that Marginal Revenue is equal to

Marginal Cost

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Two elements to marginal revenue

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Firm increases output by

one unit

Quantity sold increases

Price Revenue

Output

Price falls

Loss of revenue

from lower price

on existing sales

Additional revenue

from one additional

saleRevenue

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Price competition can lead to perfect competition

even with two suppliers.

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Price

10

9

8

12

Marginal

cost

1 2

2

1

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Prices are greater than the perfectly competitive

level when products are differentiated

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1

2

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A merger will put pressure on prices to rise

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Ice cream

seller 1

increases

prices

Quantity sold falls

Increased

revenue

for ice

cream

seller 2

Price Revenue

Output

Price rises

Quantity sold increases

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Evidence

• Step 1 – How does competition operate?

› What decisions do firms make?

› How do they make those decisions?

› Other forms of competition - bargaining, auctions,

competitive fringe, import price taker

• Step 2 – Features of the market

› Number of firms

› Capacity constraints

› Differentation

› Market shares (revenue/quantity)

› Barriers to entry

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Quantitative and qualitative evidence

• Aim is for both types of evidence to tell the same

coherent story

• Eg 2-1 merger in manufacturing industry

› Competition operates by matching import prices

› Qualitative evidence

Internal documents regarding how set prices

› Quantitative evidence

Showed empirically that price of domestic products followed that

of imports

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Key points

• Barriers to entry are always important to assessing

market power

• Impact of existing suppliers depends upon the form

of competition

• Quantity/capacity competition – market shares are

important

• Price competition – key aspects are:

› Capacity constraints

› Level of differentiation

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Effect of mergers – Cournot competition

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Effect of mergers – Bertrand competition

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Effect of mergers – Bertrand competition

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