Section 5.2 Market power and price markups
Thus far, we have seen market power characterized in two ways:
- MP1: A seller with market power can influence the price for which it sells in the market. A buyer with market power can influence the price he pays in the market.
- MP2: A firm with market power faces a downward-sloping residual demand curve. A firm with NO market power faces a horizontal residual demand curve
The lack of market power for a perfectly competitive firm can be observed on the above graphs in the previous section. On the marginal revenue and marginal cost graph, \(MR\) is constant, equal to price, and horizontal as the firm’s residual demand. On the total revenue and total cost graph, the lack of market power drives the linear shape of \(TR\text{.}\)
Now, the perfectly competitive firm’s decision making rule - choose \(q^*\) where \(P = MC\) - allows us to construct a third characterization of market power, given below:
- MP3: A firm with market power can charge a price above its marginal cost. A firm with NO market power charges a price equal to its marginal cost.
This third characterization formalizes an intuition we developed earlier, that market power can be used advantageously by the firm who has it. Here, the advantage is that a firm with a market power can collect a price above its marginal cost for every unit sold.
Let’s examine the perfectly competitive firm. On the graph below, which we’ve seen before, marginal cost is increasing, while the price is constant. On every unit prior to the optimal one, the firm collects a price above its marginal cost. According to marginal analysis, this is precisely why the firm wants to keep producing! But for the last unit, where \(P = MC\text{,}\) the firm charges a price exactly equal to its marginal cost.
One way to think of this condition is to see that for the last unit, the competitive firm cannot mark up its price above its marginal cost. A price markup is the amount above cost a firm is able to charge for its output. Because the firm cannot markup at all, the last unit generates zero additional profit. The fact that the price it charges just covers the cost of the last unit speaks to the weakness of the firm’s position and its lack of market power 1 .
By contrast, a firm with market power will have the ability to mark up its price above its marginal cost for all units sold, including the last one. That monopolistic firms continue to make positive profit on all units speaks to its advantageous position in the market. This advantage takes the form of the market power firm charging higher prices than a competitive firm would, all else equal.
One simple measure of market power is to look at the price markup measure, the ratio of the price the firm charges to its marginal cost at its last unit, \(q^*\text{.}\) Simply, the price markup measure is defined as
\begin{equation*}
\frac{P}{MC}
\end{equation*}
Since a firm with no market power will choose to produce where \(P = MC\text{,}\) the firm’s price markup measure will be exactly equal to one. This suggests the firm has no market power, because there is no price markup. A firm with market power, however, will charge a price above marginal cost, which will drive the price markup measure to be greater than one. In summary,
- If a firm has no market power, \(\frac{P}{MC} = 1\text{.}\)
- If a firm has market power, the price markup measure\(\frac{P}{MC} > 1\text{.}\) 2
Importantly, more than distinguishing between firms with and without market power, the price markup measure \(\frac{P}{MC}\) gives us a measure of how much market power a firm has. A larger price markup measure translates to more market power. For example, if a firm is able to charge a price of $25 for a unit of output that cost $5 to produce, its price markup measure is
\begin{equation*}
\frac{P}{MC} = \frac{25}{5} = 5
\end{equation*}
meaning the firm is able to markup and charge a price 5 times its marginal cost. This firm has considerably more market power than a different firm that is only able to charge a price of $20 for a unit of output that cost $15 to produce. This firm has a price markup measure of
\begin{equation*}
\frac{P}{MC} = \frac{20}{15} = 1.33
\end{equation*}
This second firm still has market power, since it can charge a price above \(MC\text{,}\) but it can only charge a price 33% above its marginal cost. The market power measure identifies market power and measures how much market power a seller has in a given market.
The Lerner index gives a second measure of market power. Denoted by \(\ell\text{,}\) it gives the percentage of the firm’s price that is markup. For example, if a firm charges $25 for a unit that costs $5 to produce, then out of the 25 dollars, 5 dollars are cost, while the other 20 dollars are markup. Since 20 dollars of the 25 dollar price are markup, then 80% of the price is markup. In general, the formula for the Lerner index is
\begin{equation*}
\ell = \frac{P - MC}{P}
\end{equation*}
In the example above,
\begin{equation*}
\ell = \frac{25 - 5}{25} = \frac{20}{25} = 0.80
\end{equation*}
or, 80% of the price. If, instead, a firm charges a price of $20 for a unit of output that costs $15 to produce, its Lerner index value is
\begin{equation*}
\ell = \frac{20 - 15}{20} = \frac{5}{20} = 0.25
\end{equation*}
meaning only 25% of this firm’s price is markup. Just as with the markup measure, the higher the Lerner index value, the more market power the firm has, since markup composes a higher share of its price. As an important final check, notice what happens in perfect competition. A competitive firm has no market power, and produces where price equals marginal cost. Therefore, its Lerner index value would be
\begin{equation*}
\ell = \frac{P - MC}{P} = \frac{0}{P} = 0
\end{equation*}
0% of a perfectly competitive firm’s price is markup - because, due to its lack of market power, the firm cannot markup its price at all!
Measures of market power and price markup will become particularly handy in later chapters, when we build models of firms with market power. We can use these measures to compare degrees of market power between firms, and to see how different levels of market power impact consumer welfare and efficiency in markets. And as we will see, markup has an important relationship with another market factor: price elasticity of demand.
Key terms in this section:
- MP3
- price markup
- price markup measure
- Lerner index
