Sources of Market Power

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Market power in economics is the ability of a firm or firms to influence the price of goods by controlling supply or demand. In theory, there is no market power because all firms are in perfect competition, which means that there are many nearly identical firms producing nearly identical goods; if one firm raises prices, buyers will simply choose a similar product at a cheaper price. However firms are not always in perfect competition, and some firms -- those that are monopolies or oligopolies -- do enjoy market power.

Monopoly and Monopolistic Competition

  • In the most extreme sense, a monopoly is a single supplier that controls a market for a product or service. In reality, however, strict monopolies are rare. More common is monopolistic competition, where there are many sellers producing similar but differentiated products; in other words, their products are not perfect substitutes for one another. Both firms that are monopolies and those that are in monopolistic competition have market power. They are price makers and can raise prices without losing market share.

Types of Monopolies

  • True monopolies can occur when a firm has exclusive access to a market for some reason, and there are barriers to entry for potential competitors. This is common when a government grants rights to a certain company to supply a service -- train transportation or water distribution, for example -- or when a company obtains a patent or copyright. The company then has a legal monopoly. A natural monopoly forms when one firm can supply an entire market at a lower cost than if two or more firms entered the business. Another type of monopoly occurs when a company acquires exclusive ownership of a natural resource such as diamonds.

Oligopoly

  • An oligopoly is a system in which at least two firms or entities dominate a market. These firms have some market power even though their product is identical or nearly identical because they are insulated from competition. A cartel such as OPEC -- Organization of the Petroleum Exporting Countries -- is a classic example of an oligopoly. A cartel is an organized group of sellers that colludes to manipulate prices of a particular product, oil in the case of OPEC, to the advantage of cartel members.

Monopsony

  • Sometimes it's not the supplier who has the market power, but the customer. A monopsony occurs when there is one buyer and many producers and the buyer has the power to drive prices lower by controlling demand. A classic example is the labor market and wages, in a case when there is one major employer and many people looking for jobs. In another example, large supermarkets can have monopsony power over food prices if sellers, particularly small farmers, are unable to find alternative buyers for their goods.

References

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