Market power

The dividing line between a competitive market and a problematic one is market power: the ability of a firm to raise its price above cost and make it stick.

Market power is the ability of a firm to raise the price of its product above marginal cost, the competitive level, without losing all its customers. It is the central concept in understanding how real markets depart from perfect competition, and the thing competition policy ultimately concerns itself with.

The spectrum of power

Market power is not all or nothing but a matter of degree. A firm in perfect competition has none: it is a price taker, and any attempt to charge above the market price loses all its sales. A pure monopolist has a great deal, constrained only by the overall demand for its product. Most real firms sit between these poles, possessing some market power, from the modest power that product differentiation confers in monopolistic competition to the substantial power of a dominant firm in a concentrated industry. The question is rarely whether a firm has market power but how much.

Where it comes from

Market power arises from anything that insulates a firm from competition. Product differentiation and brands give a firm power over those who prefer its offering. Barriers to entry protect incumbents from new rivals. Control of an essential input, network effects, switching costs that lock customers in, and economies of scale that deter smaller competitors all confer power. The more a firm is shielded from the discipline of rivals and potential entrants, the more it can raise price above cost without being undercut.

Why it matters, and its limits

Market power matters because it allows firms to raise prices, restrict output, and earn profits at the expense of efficiency and consumers, the harms competition policy seeks to limit. But the concept requires care. Some market power is the normal and even desirable reward for genuine differentiation or innovation, and the temporary profits it brings can be what motivates firms to improve. The concern of policy is not the existence of market power as such but its abuse, and its entrenchment behind barriers that prevent competition from eroding it.

Market power is the unifying idea behind the study of market structure, the measure of how far a firm escapes the discipline of competition. Identifying its sources, gauging its extent, and judging when it crosses from a fair reward into a harm that policy should address is much of what industrial economics and competition law are about.