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Why is abuse of Market Power a form of Market Failure?
Why is abuse of Market Power a form of Market Failure?
In this unit we will look at why the abuse of market power can create an underallocation of resources in a market. Up until this point, we have made a number of assumptions about free markets, the goods produced and the information between stakeholders.
However, when one or more of these assumptions may not be true, then we have a situation whereby one firm may be able to gain high levels of market power in the form of monopolies or a few dominant firms in the industry can collude to maximise their profits (Collusive oligopolies). When firms are able to abuse their market power and set their own prices, the good may be underallocated as a result. Therefore, in this unit we will go into more detail on how firms operate and how understanding this, can help us understand why, the abuse of market power may create a market failure.
Assumptions of Perfect Competition
Assumptions of Perfect Competition
A large Number of Firms in the Market
Homogenous Goods causing the firm to take the market price
No barriers to enter or exit
Perfect Knowledge
Although a highly unrealistic market structure, it helps us understand the importance of competition to achieve market efficiency and how this can help achieve allocative efficiency. The closest markets to show characteristics of perfect competition would be: commodities such as gold or oil, agricultural commodities such as rice, wheat or foreign exchange markets. Each firm in these markets is relatively small and therefore limited power to influence the price and instead ,the market prices tend to be determined by market forces.
Assumptions of Monopolistic Competition
Assumptions of Monopolistic Competition
A large number of small or medium sized firms
No Barriers to entry
Product Differentiation giving firm some control over the price
Similar to perfect competition in the sense of a large number of firms, monopolistic differs because it is able to differentiate its products. As such, it is able to set the price it charges for its goods. We can see Monopolistic Competition in markets such as clothing, small restaurants or furniture industries. The firm has some power to set its prices but this is limited by the fact there are a large number of firms in the market producing similar (but not close substitute) goods.
Assumptions of Oligopolies
Assumptions of Oligopolies
A small number of Large Firms
Products are either differentiated or homogenous
Firms are Interdependent
High Barriers to Enter and Exit the Market
Due to there being a small number of large firms, Oligopolies have considerable power over the market. These firms produce either homogenous (oil) or differentiated goods (cars). Due to the small number of large firms and high barriers to entry, there is sometimes the incentive for Oligopolistic firms to collude and form a cartel.
Assumptions of Monopolies
Assumptions of Monopolies
One dominant firm in the market
Sells unique good or service with no close substitutes
High Barriers to Enter and Exit the Market
Monopolies have incredibly high market power. Being the sole provider or dominant provider of a good provides the monopoly with the ability to set the price of a good. Therefore, monopolies in private markets can bring negative effects to society as a whole. However, due to the economies of scale a large firm can benefit from, some natural monopolies exist. For example, Public utilities such as water, electricity or postal services may be better as a natural monopoly to lower costs and therefore lower prices for consumers.
Pricing Decisions in Market Structures
Pricing Decisions in Market Structures
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