Lecture 1 - Sources of Market Power

1. Purpose of the Lecture

This lecture introduces market power as the central organising concept of the module. Rather than treating competition as the norm, the lecture begins from the empirical observation that most real-world markets deviate from perfect competition. The goal is to understand why this happens, how market power arises, and how it shapes firm behaviour and market outcomes.

The lecture also establishes the Structure–Conduct–Performance (SCP) paradigm, which provides a unifying framework for analysing industries.

2. Stylised Facts About Real-World Markets

The lecture begins by challenging the explanatory power of perfectly competitive models through a set of stylised facts.

Fact I: Variation Across Industries

Competitive market theory struggles to explain:

  • Why the number of firms differs across industries
  • Why firm size distributions vary substantially
  • Why profitability differs persistently across sectors

If markets were fully competitive, we would expect:

  • Many firms
  • Similar firm sizes
  • Zero long-run profits

Empirically, this is not what we observe.

Fact II: Product Characteristics Differ

Markets differ according to the nature of products:

  • Homogeneous products (e.g. basic commodities)
  • Heterogeneous products (e.g. branded goods)

Product differentiation weakens price competition by reducing the availability of close substitutes, thereby increasing market power.

Fact III: Costly Non-Production Activities

Firms engage heavily in activities that are not directly related to production:

  • Advertising
  • Product differentiation
  • R&D
  • Technological and product innovation

These activities are rational only if firms expect to earn market power rents. Under perfect competition, such expenditures would not be recoverable.

Fact IV: Strategic Firm Behaviour

Firm behaviour is strategic, not passive. Firms account for:

  • Rival actions
  • Buyer responses
  • Supplier behaviour
  • Government intervention

This interdependence is especially important in oligopolistic markets and motivates the use of strategic models later in the module.

Fact V: Government Involvement

Governments:

  • Regulate firm conduct
  • Restrict entry
  • Set standards and licences
  • Influence prices and costs

This institutional environment plays a crucial role in shaping market power.

3. Market Power: Definition and Core Insight

Definition

Market power is defined as:

A firm’s ability to profitably raise the market price above marginal cost.

Formally:

This definition links market power directly to:

  • Pricing ability
  • Demand elasticity
  • Barriers to competition

A key implication is that market power decreases as the number of competing firms increases.

4. Market Structures and Market Power

The lecture places market power within the context of four canonical market structures.

Comparison of Market Structures

Market Structure Number of Firms Entry Barriers Product Differentiation Long-Run Profit
Perfect Competition Many None Homogeneous Zero
Monopolistic Competition Many Small to moderate High Zero
Oligopoly Few High Homogeneous or differentiated Positive
Monopoly One Impassable Absolute Highest

Market power increases as:

  • Entry barriers rise
  • Product differentiation strengthens
  • The number of firms falls

5. Sources of Market Power

The lecture categorises sources of market power into institutional, non-strategic economic, and strategic economic barriers.

5.1 Institutional Barriers to Entry

These are created or enforced by government policy.

  • Zoning

    • Restricts economic activity to specific locations
    • Can grant monopoly power over land or access

  • Licensing

    • Requires government permission to operate
    • Often justified by health or safety concerns
    • Can limit entry and reduce competition

  • Patents and Copyrights

    • Grant temporary legal monopolies
    • Intended to incentivise innovation
    • Restrict entry by design

  • Tariffs

    • Taxes on imports
    • Protect domestic firms from foreign competition

Institutional barriers highlight that market power is often policy-created, not accidental.

5.2 Non-Strategic Economic Barriers

These arise from cost and technology conditions rather than deliberate firm actions.

  • Absolute Cost Advantage

    • Incumbents produce at lower cost than entrants

  • Sunk Costs

    • Large, unrecoverable start-up investments
    • Deter entry due to high risk

  • Economies of Scale

    • Average costs fall as output increases
    • One firm may efficiently serve the entire market

These barriers imply that monopoly or concentration can sometimes be cost-efficient, complicating welfare analysis.

5.3 Strategic Economic Barriers

These are deliberate firm actions designed to deter entry or soften competition.

Key examples include:

  • Limit pricing: pricing aggressively to make entry unprofitable
  • Advertising: creating brand loyalty and reducing demand elasticity
  • Reputation: signalling toughness to potential entrants
  • Collusion: explicit or tacit agreements to restrict competition
  • Price discrimination: charging different prices to different consumers
  • Bundling and tying: linking products to reduce rival competitiveness
  • Lock-in: creating switching costs for consumers
  • Vertical integration: controlling multiple stages of production
  • Networks: increasing product value with user base size
  • Unionisation: increasing bargaining power in input markets

Strategic barriers are central to later lectures on advertising, innovation, and networks.

6. The Structure–Conduct–Performance (SCP) Paradigm

The SCP paradigm, associated with the Harvard School, provides a causal framework:

  • Structure

    • Number of firms
    • Product differentiation
    • Entry barriers
    • Cost structure

  • Conduct

    • Pricing behaviour
    • Production strategy
    • Advertising and R&D
    • Collusion and mergers
    • Investment decisions

  • Performance

    • Allocative and productive efficiency
    • Technological progress
    • Employment
    • Product quality
    • Profits

Core Insight

Industry performance depends on firm conduct, which in turn depends on market structure.

Government policy affects all three layers through:

  • Regulation
  • Antitrust
  • Taxes and subsidies
  • Entry restrictions
  • Investment and employment incentives

7. Key Takeaways for Exams

  • Perfect competition is empirically inadequate for explaining real markets
  • Market power is the ability to price above marginal cost
  • Entry barriers are central to understanding market power
  • Distinguish clearly between institutional, non-strategic, and strategic barriers
  • The SCP paradigm provides the analytical backbone of the module

Strong answers will connect market structure to firm behaviour and welfare outcomes, rather than treating market power as a purely technical concept.

Bibliography

Perloff, J.M. (2017) Microeconomics: Theory and Applications with Calculus. 4th edn. Harlow: Pearson.

Tirole, J. (1988) The Theory of Industrial Organization. Cambridge, MA: MIT Press.

Cabral, L. (2017) Introduction to Industrial Organization. 2nd edn. Cambridge, MA: MIT Press.