The economics of market power

The theory of monopoly

    All firms seek to obtain, consolidate and expand market power. Many firms have

some degree of market power but, in the majority of cases, it is not sufficient to

cause significant deviations from a competitive market outcome. Other firms

occupy strong monopoly positions. Firms in this category account for a significant,

if not strictly determinable, proportion of total marketed activity. To understand

the market system in its entirety, therefore, we need to know how the

system functions when individual firms possess significant market power.

Specifically, we need to know the consequences of this power for the firm’s

price and output decisions, how market power is attained and sustained,

the systemic implications of market power, and how policy-makers should

respond to it. We discuss the first two issues in this chapter and the others in

Chapter 7.

    The consequences of market power can be explained with the analysis of the

firm described in Chapter 5. For simplicity, we take the extreme case of a singleproduct monopoly. We assume its costs are U-shaped .Demand conditions

are represented by the demand curve DD, from which the marginal revenue

curve MR can be derived. Applying the profit-maximisation rule MR # MC gives

the equilibrium output of OQ_m. The market-clearing price for that output is OP_m.

The average cost at that output level is SQ_m. Monopoly profits are then the average profit margin RS multiplied by output OQ_m. They are represented by the area of the rectangle P_m_RSF.

    Market power means that an individual firm’s output affects price. Thus,

suppose production were raised above OQ_m to OQ,. Price would have to fall to

OP,. Corresponding to that price and output, we have MC # Q,S, and MR # Q,T,.

Note that MR ` MC. This implies that the net increase in revenue obtained by

raising output by Q_m_Q, is less than the cost of producing that extra output. Hence

total profits must be lower at output OQ, than at OQ_m. The profit-maximising

monopolist, therefore, will cut back sales to OQ_m. The profit-maximising rule prevents the firm from selling either more or less than OQ_m. This is why Q_m and P_m are monopoly equilibrium price and quantity.

    The economic consequences of the monopoly are estimated by reference to the

benchmark case of competition We start off from the monopoly equilibrium. Only this time, for convenience of exposition, constant costs over the relevant output span are assumed .The monopoly sells OQ_m at price OP_m. Now assume that competition is introduced into the industry. Each plant is taken over by an independent owner. The plants are numerous, so each single owner can have no influence on price. Hence, MR # P for each individual firm. The profit-maximising rule leads each firm to produce up to the point where P # MR # MC. In Figure 6.2, this corresponds to point S, with output OQ_c   and price OP_c .The welfare loss of monopoly is the triangular area RTS. Intuitively, this represents the total utility derived from the addition of Q_m_Q_c to extra output, measured by Q_m_RSQ_c less the actual resource cost of producing it represented by the area under the MC curve, Q_m_TSQ_c. The creation of this so-called ‘dead-weight’ loss of monopoly constitutes the standard ‘static’ argument against monopoly.

The economics of market power

Competition is an enduring and pervasive fact of business life. Although the

intensity of competitive pressure varies according to type of industry and stage of

the business cycle, most managers recognise a broad similarity between their own

experience and many aspects of the competitive model of the previous chapter.

High profits attract new entrants; losses lead to exits. Prices cannot be realistically

altered without regard to the ‘market’ rate, and so on.

    Yet one important aspect of business reality is market power. Up to now, we

have assumed that firms have negligible market power. Each firm is so small in

relation to the total size of the market that it takes the going market price as

‘given’ and can safely ignore other firms’ reactions to its sales or price decisions.

There are too many producers to make any such interdependence

worth considering. This assumption is now relaxed. Firms are allowed to

have monopoly, or market, power.

    The way firms use, and maintain, market power is the subject of this chapter.

Firm size

    ‘Corporate giantism’ is a feature of many parts of the economy. In the automobile,

aircraft and oil industries, large scale is the norm rather than the exception.

The top four meat-packing firms in North America slaughter 84 per cent of

US cattle. Wal-Mart employs over one million people – a workforce more than

half the size of the total working population of a small country such as Ireland,

and held over 60 per cent of the retail discount trade of the US in 2001. Among

Europe’s major employers, DaimlerChrysler, Siemens and Unilever have become

household names, as have the state-owned communications and transport companies.

    At the opposite end of the spectrum are the small and medium-sized enterprises

,defined as enterprises employing fewer than 250 persons. In 2000, there

were 19 million such enterprises in Europe-19 (the EU countries, Iceland,

Liechtenstein, Norway and Switzerland). Although comprising only a fraction

of the total number of enterprises, the 40,000 enterprises with 250 or

more employees accounted for 34 per cent of the EU’s workforce in services and

industry of 122 million._1 Enterprises employing fewer than 10 persons employ 42 million or just over one-third of the total. Micro-firms are heavily represented in retail distribution, construction and personal services

    Almost half of all US firms are SMEs. Firms with fewer than 250 workers

account for 46 per cent of private sector employment._2 The vast majority of US

firms had sales below $10 million per year.

Firm size, concentration ratios and market power

    Some rough indication of the proportionate strength of competitive forces in the

economy can be gleaned from examining the proportion of small relative to large

firms in an economy. Suppose one starts with the assumption that sectors with

large numbers of small enterprises are more likely to have the characteristics of a

competitive market than sectors dominated by the larger enterprises. On this

basis, since 66 per cent of the EU workforce is employed in SMEs, we could infer

that 66 per cent of total marketed activity approximates the conditions of

the competitive market and the remaining 34 per cent could be classified as

monopolistic. This is a crude indicator, however, since, as we have seen, on the

one hand large firms are not incompatible with competition and on the other the

prevalence of small firms does not guarantee competition.

    Another approach is to focus on concentration ratios. Concentration ratios are a

commonly used measure of the degree of market power at industry level. These

ratios measure the percentage share of industry sales, or employment, accounted

for by the largest companies. A C4 of 70 per cent, for example, indicates that the

largest four firms account for 70 per cent of industry sales. A C10 of 85 per cent

indicates that the 10 leading companies account for 85 per cent of industry

output. The concentration ratio is a widely used measure of the degree of market

power in an industry._3 Typical illustrations of information expressed in this way: six firms accounted for 80 per cent of worldwide music sales in the mid-1990s, while one firm accounts for 40 per cent of the global tea distribution market.