Behavior and Choice: EC 102

The concept of market power is critical to understanding market behavior. Both buyers and sellers can have market power, but for now, let’s focus on sellers with market power. In the broadest terms, a buyer or seller with market power has some influence in the market. But influence over what? And how does this influence manifest itself in the market?

Simply put, market power is about ability to influence price. This power is generally good for the actor who has it: a seller with market power can use that power to ask for a higher price for the good or service it sells, while a buyer with market power can use that power to pay a lower price for a purchase.

An actor without market power has no ability to influence the price they ask for or pay. Consider walking into a supermarket to purchase an avocado. Would you be able to negotiate the price with the cashier or manager? “Hi, I know this avocado is priced at $1.50, but I’d like to pay $0.75 for it.” This likely wouldn’t go well! Most buyers don’t have market power, because in most markets, there are a large enough number of buyers that no buyer could influence the price. Since sellers have enough other buyers to sell to, no single buyer has any leverage to change the price.

Market power can arise in markets where there are a small number of actors. As a single seller in the market, a monopoly has market power; similarly, firms in oligopolistic competition have market power. Buyers have fewer alternatives to turn to with so few sellers, so the higher-than-otherwise price can be sustained. Market power does not mean that firms in these markets can charge whatever price they want. Rather, very simply, it means that these firms have influence over the price.

What about markets with many firms? Monopolistically competitive firms do have market power, despite the abundance of firms. In these markets, market power arises because of the differentiated products across firms. Since firms sell products that are slightly unique, this uniqueness allows the firms to maintain a bit of influence over their price. When a monopolistically competitive firm sells its differentiated product, since there are consumers who have a preference for this product, the firm can ask for a higher price. This market power may not be as strong as in oligopolies or monopolies, but it exists.

In perfectly competitive markets, however, there are many firms and all products are identical! Therefore, firms have no basis for asking for a higher price for its goods. There are a large number of competitors, all selling products that are identical, so if one firm asks for a higher prices, buyers can simply seek out a competitor selling the same good at the lower price. Perfectly competitive firms have no market power. Often, we say perfectly competitive firms are price-takers, suggesting that without any capacity to influence the price, firms must take the price in the market as given. Below, we see the market structure grid from above, highlighting which firms have market power. Firms in monopoly, oligopoly, and monopolistic competition all have market power. Firms in perfect competition are actually the exception: this is the only primary market structure where firms lack market power. This makes perfectly competitive markets fairly unique.

Common market structures showing market power. Market structures where firms have market power are denoted with a blue checkmark (\checkmark), while in perfect competition, the lack of market power is denoted with a red X (X).

So, what are the consequences of a seller having market power? Why does it matter to have influence over the price?

Price matters because it influences how many units of a good consumers will demand. Therefore, a firm with market power (who can therefore influence price) can also influence the number of units of its product demanded. In chapter 1, we introduced the notion of residual demand, which is the demand faced by the firm. With residual demand, we view the demand relationship - how many units are demanded at a given price - from the firm’s perspective. Since for the moment, our focus is firm market power, residual demand is where the impact of that marker power will be felt.

We say a firm with market power faces a downward-sloping demand function, such as \(Q_D = 200 - 10P\text{,}\) because a change in firm price causes a change in the number of units demanded by consumers. A firm facing \(Q_D = 200 - 10P\) knows that if it charges a price of 12, consumers will demand 80 units. The firm also knows that if it increases its price to 15, consumers will demand only 50 units.

The downward-sloping nature of residual demand here captures a tradeoff, the inverse relationship between price and quantity for the firm. A firm with market power can use its market power to raise price, but since it has market power, the price increase will result in a lower quantity demanded. Conversely, a firm with market power could consider selling higher quantity of output, but in order to increase the quantity sold, the firm would have to lower its price. This tradeoff shows the double-edged nature of market power. A firm with market power does have the ability to increase price, but when it does so, it will lose customers; if it increases its price too far, it will surely have an unambiguously negative impact on its revenue.² Along the same lines, a firm with market power has a weak incentive to produce a high quantity, since selling a higher quantity necessitates a price decrease and undermines firm revenue.

This can be captured in the algebraic expression for total revenue, using inverse demand. Recall that when demand is \(Q_D = 200 - 10P\text{,}\) inverse demand is \(P = 20 - \frac{1}{10}Q_D\text{.}\) While demand can be interpreted by the firm thinking “at a price of 12, consumers will demand 80 units,” inverse demand can be interpreted by the firm thinking “if my objective is to sell 80 units, the highest price I could charge to sell 80 units is a price of 12.” Plugging a target \(Q_D\) into inverse demand gives the highest price which would still yield that quantity.

We know total revenue is price × quantity. When a firm has market power, and can influence its price, price is given by the inverse demand function, \(P = P(Q)\text{,}\) since the price a firm will ultimately charge depends directly on the number of units it wants to produce, and therefore price is a function of quantity! Total revenue can then be expressed as \(TR = P(Q)\times Q\text{.}\) With the numerical example above, \(TR = (20 - \frac{1}{10}Q)Q = 20Q - \frac{1}{10}Q^2\text{.}\) The upside-down U-shaped total revenue curve (as seen below) equivalently captures the price-quantity tradeoff, the double-edged nature of firm market power.

If a firm operates in a perfectly competitive market and has no market power, it cannot influence the price it can charge. By contrast, then, when this firm generates revenue \(TR = P\times Q\text{,}\) this price \(P\) is a constant! If the price in a perfectly competitive market is \(P = 20\text{,}\) then whether any individual firm produces 2 units of output or 200 units of output, the price does not change. Therefore, it stays constant in the firm’s total revenue calculation. At a price of 20, for example, total revenue can then be written as \(TR = PQ = 20Q\text{.}\)

This lack of market power has two impacts on the shape of the firm’s problem. First, since the price cannot change in response to a change in quantity from a firm, then each firm in a competitive market faces a demand that is horizontal. It is flat, suggesting that the price remains unchanged at any quantity.³ While a flat demand curve seems odd, remember that this is the residual demand curve for a firm: the way demand looks from the perspective of the firm. The demand for all consumers in the market is still likely to have its typical downward-sloping shape.

Second, the lack of market power nullifies the tradeoff between price and quantity firms with market power must make. As a competitive firm increases the number of units it wants to sell, the price does not change. Therefore, there is no negative impact on revenue resulting from a price decrease! A s a result, a competitive firm has a strong incentive to increase output. This can be observed in the shape of the competitive firm’s total revenue function, which is linear (\(TR = 20Q\text{,}\) for example) and grows continuously. Notice as well that total revenue can still be visualized on the graph of the firm’s residual demand curve as the area under the curve at a given point, since \(TR = P\times Q\text{,}\) and the coordinates of any point are its price and quantity. It is clear that as the firm increases production, this area - and the firm’s revenue - gets infinitely large.⁴

We recap the comparison of market power and no market power in the table below. Market power manifests itself in many ways. Importantly, this distinction is critical in understanding both how firms behave to maximize profit, and how this behavior influences outcomes, in different market structures. We will study profit maximization and market interactions in perfect competition in the next chapter. This will serve as our initial benchmark, against which we will compare behavior in the presence of market power.

Comparison of market structures where firms have NO market power, such as perfect competition (left column), and market structures where firm HAVE market power (right column), such as monopoly, oligopoly, and monopolistic competition.