Monopoly Power

Monopoly power is the ability of a firm to raise its price above the competitive level without losing all of its sales. Monopoly power is a matter of degree, ranging from the power of a single seller in a market with no substitutes to the limited power of a firm in a market with many close substitutes.

Sources

Monopoly power arises from several sources. Barriers to entry, including legal restrictions, control of essential inputs, and economies of scale, protect firms from competition and allow them to sustain prices above the competitive level.

Product differentiation gives firms a degree of market power, since consumers regard the products of different firms as imperfect substitutes. The more differentiated the products, the greater the power of the firms to raise prices.

The ownership of patents and of other intellectual property gives firms a temporary monopoly, which provides an incentive to innovate. The trade-off between the incentive to innovate and the cost of the resulting market power is a central issue in the design of intellectual property policy.

Measurement

Monopoly power is measured by several indicators. The Lerner index measures the markup of price over marginal cost, which is the direct measure of market power. The index ranges from zero, for a competitive firm, to one, for a firm with complete power.

The concentration of the market is used as an indicator of the potential for market power, since a market with few firms is more likely to sustain prices above the competitive level. The measures of concentration include the concentration ratio and the Herfindahl-Hirschman index.

The measurement of market power is complicated by the difficulty of defining the market and by the fact that the observed price may reflect other factors, including the quality of the product and the costs of the firm.

Effects

The exercise of monopoly power reduces output below the efficient level and raises the price above marginal cost, creating a deadweight loss. It also transfers income from consumers to the firm, which raises distributional concerns.

Monopoly power can also affect the incentives to innovate and to invest. The prospect of monopoly profits provides an incentive to develop new products and to improve existing ones, while the absence of competition may reduce the pressure to be efficient.

The effects of monopoly power on welfare are therefore complex. The static loss from the exercise of market power must be weighed against the dynamic gains from the innovation and the investment that it may induce.

Policy

Competition policy addresses monopoly power through the prohibition of anticompetitive practices, the control of mergers, and the regulation of firms with substantial market power.

The design of competition policy must balance the benefits of competition against the efficiencies that may arise from the concentration of production. The assessment of mergers, for example, considers both the reduction in competition and the cost savings that the merger may achieve.

Monopoly Power and Innovation

The relationship between monopoly power and innovation is a central issue in the analysis of the economy. The prospect of monopoly profits provides an incentive to innovate, since a firm that develops a new product can capture the returns.

The protection of intellectual property, through patents and other instruments, provides a temporary monopoly to innovators. The design of the protection must balance the incentive to innovate against the cost of the market power that it creates.

The empirical evidence on the relationship between market structure and innovation is mixed. Some studies find that innovation is highest in markets with a moderate degree of concentration, where firms have the resources to innovate but also face competition. The relationship depends on the industry and on the type of innovation.

Monopsony Power

Monopsony power is the counterpart of monopoly power on the buying side of the market. A firm with monopsony power can pay a price below the competitive level for the inputs that it purchases, including labour.

The analysis of monopsony power is relevant to the labour market, where a dominant employer can pay wages below the competitive level. The presence of monopsony power affects the analysis of the effects of the minimum wage, since a minimum wage can raise wages and employment when the employer has monopsony power.

The measurement of monopsony power is difficult, since it requires information about the alternative opportunities of the suppliers. The evidence suggests that monopsony power is more prevalent than was once thought, particularly in labour markets that are geographically isolated or that require specialised skills.

Competition Policy

Competition policy addresses monopoly power through the prohibition of anticompetitive practices, the control of mergers, and the regulation of firms with substantial market power. The design of the policy must balance the benefits of competition against the efficiencies that may arise from the concentration of production.

The assessment of mergers considers the effect on competition and the cost savings that the merger may achieve. The framework used for the assessment has evolved, with greater emphasis on the effects on consumers and on the use of quantitative methods.

The enforcement of competition policy is a central task of the authorities, and its effectiveness depends on the resources available and on the legal framework. The cooperation among authorities across countries is important, since many markets are international.

Summary

Monopoly power is the ability of a firm to raise its price above the competitive level, and it arises from barriers to entry, from product differentiation, and from the ownership of intellectual property. Its analysis informs the design of competition policy and the understanding of the effects of market structure on the economy.

See also

• Market Structure
• Industrial Organization
• Competition Policy