When private markets fail: market power

Today’s post is a primer on an important source of market failure. A key requirement for private markets to work well is that no single buyer or seller can influence the market price. This means that buyers and sellers essentially face take-it-or-leave-it options. When this requirement isn’t met, we say that there is “market power.”

Market power exists when a firm can affect the price of what’s being bought or sold, at least to some extent. When that happens, the market outcome stops being efficient.

In reality, most sellers have at least some market power, but the less they have, the less problematic the situation is. So let’s start by considering a monopoly — the most extreme form of market power.

Think about a drug that’s under patent. If only one company is allowed to produce it, that company can charge a very high price — much higher than what it costs to make. In a perfect world, society would want everyone who’s willing to pay at least what it would cost to manufacture the drug to have it. When there’s no market power or other market failures, private markets accomplish this.

But if there’s market power, like with a monopolist, fewer units of the drug are sold than would be ideal from society’s perspective. The firm maximizes its profits, but the market fails to serve everyone who’s willing to pay at least what the good costs to produce.

And market power isn’t just about monopolies. Companies in industries with a few dominant players — like commercial airlines or wireless providers — can still raise prices substantially above competitive levels. They might also collude implicitly, avoid aggressive competition, or erect barriers to entry that keep out smaller rivals. That leads to higher prices, lower output, and sometimes less innovation.

Buyers can have market power too. If there’s only one major employer in a town — a monopsony — that firm can use its leverage to pay lower wages than would hold in a truly competitive market. Workers might have no real alternative, so even if they’re productive, they may not be paid what they’re worth. And some workers may choose to stay out of the labor force instead of working for monopsony wages. Just like on the seller side, even if there’s more than one buyer, there may not be enough of them to come close to the competitive outcome. Again, the market outcome deviates from the ideal.

Market power generally leads to what economists call “deadweight loss” — value that’s lost to society because the private market isn’t working well-and government intervention can become beneficial.

What can governments do? One key policy is strong antitrust policy and enforcement — punishing companies who abuse their market power, preventing anti-competitive mergers, or in some cases even regulating prices directly. For example, the government has long regulated sectors like electricity distribution because of their tendency toward a so-called “ natural monopoly.” On the buyer side, ensuring that companies don’t abuse strategies like non-compete agreements can also help.

The bottom line is this: markets work best when there’s a lot of competition and no buyer or seller can wield an outsized influence. Otherwise, we get prices that are too high, wages that are too low, and innovation that slows down. Keeping the playing field level and fostering competition is essential for a healthy economy.

Originally published at https://mytwocentsandcounting.substack.com.