What Does Market Failure Mean? Part 1: Market Power

Jason Clemens and Marc Law

The efficiency of markets

Adam Smith noted that, if individuals are left to pursue their own self interest, they will be led, as if by an "invisible hand," to act in a manner that maximizes society's well-being. (footnote 1) If self-interested individuals are left to "truck, trade and barter" on their own, they will trade until all possible gains from exchange have been exhausted. In other words, they will reach an allocation of resources such that it is impossible to make someone better off without making someone else worse off. An allocation that satisfies this criterion is said to be "Pareto efficient." (footnote 2) Perhaps the most important insight of modern neoclassical economics is that under certain conditions, the free market allocation of resources—the allocation which results from individuals acting in their own self interest—will be "Pareto efficient." (footnote 3) That free markets can lead us to such outcomes is testimony to the power of markets to maximize the value of economic exchange.

Of course, free markets will maximize the gains from trade only under a particular set of conditions. Indeed, much of modern microeconomic theory is devoted to analyzing what happens to economic efficiency when these conditions are relaxed. "Market failure" refers to all those instances where the conditions required for markets to be efficient are not satisfied. If the market fails, then there is some allocation of resources, that could, in principle, result in at least one person being made better off without someone else being made worse off. In other words, when the market fails, the gains from voluntary exchange have not been fully exhausted, and so it follows that the free market has not maximized the value of economic activity. (footnote 4)

The conditions required for markets to be Pareto efficient are, unfortunately, too numerous to explain in detail in the space of a short article. Hence, over the next few months, we will concentrate on a few of the most "popular" market failures and discuss them in simple terms. Furthermore, we will briefly evaluate the rationale for government intervention in cases of market failure and some of the potential pitfalls resulting from such intervention. In this article, we will discuss the concept of market power and the effect it has on economic welfare.

Market power: price-setting behaviour

The first requirement for free markets to be efficient is that the market be competitive. A competitive market is one in which there are enough producers and consumers such that no particular market participant has any influence over price. In economists' jargon, the participants in such a market are "price-takers." In such a market, all players take the market price as "given" and make their decision to supply or demand that product on the basis of this given price.

To illustrate a competitive market, consider the following hypothetical example. Imagine that there exists an economy where there are thousands of consumers and producers of beer. Furthermore, assume that the cost of producing each bottle of beer is $1. Because there are so many beer producers and consumers in this economy, no individual beer consumer or producer can influence the market price. Individual producers are unable to affect the market price since a reduction in price would cause financial losses, and an increase in price would motivate consumers to switch their consumption to other brands. Similarly, consumers are unable to negotiate a lower price since their individual purchases account for a minuscule portion of total sales. Participants in the beer market are therefore price-takers since each participant only makes up a small component of the total demand or supply of beer. In such a market, the equilibrium price of beer—the price that results from the interaction of consumers and producers—will be $1. At this price, the gains from trade are maximized.

Suppose that there is only one beer producer in our hypothetical economy—assume that there is a monopoly. (footnote 5) If there is only one producer of beer, then it is possible for that producer to affect the market price because he is the only producer. He can raise the price of beer by reducing production. The supply decision has a direct influence on the market price since the producer is a "large" part of the market. Hence, he has an incentive to produce less than would be produced under competitive conditions in order to increase profits. The result is that the value of economic exchange is not maximized.

The reason that economic welfare is not maximized is that when producers have market power, they produce "too little" output, or less output than would be produced in a competitive market. A profit maximizing beer monopolist will therefore set the price of beer above $1 because that company has the market power to do so. This is because at any price above $1, the beer producer earns extra profits. However, when the price of beer exceeds $1, there are consumers whose willingness to pay for beer equals or exceeds the supplier's cost of producing beer ($1). Gains from trade are not fully exploited since these individuals could be made better off if they could consume beer sold at competitive market prices. The failure of the market to fully exploit these gains from trade means that when suppliers have market power, the free market outcome will not be Pareto efficient. Therefore, there exists, in principle, another allocation which is superior to that which occurs under a free market. It is thus that market power is a source of market failure.

Government intervention in cases of market power

Many economists and policy makers believe that the presence of market power constitutes a rationale for government intervention. The standard argument offered is as follows: market power on the part of suppliers results in "under production" of goods. Therefore, government should intervene to force producers to produce the "right" amount and thus, maximize social welfare. (footnote 6)

Government intervention to correct for market power takes many forms. In the case of monopoly, government intervention often involves outright ownership and control. The government simply takes over the monopoly and tries to produce the optimal amount of output. Examples of this are Ontario Hydro, or the Insurance Corporation of British Columbia (ICBC), both state-run public monopolies.

In other instances, production continues to take place under private ownership, but some control is relinquished to public regulators who can influence the amount the firm charges and the amount it produces. The CRTC is an organization through which the state regulates the behaviour of private telecommunications firms.

A third way by which governments attempt to reduce market power is through competition law. Through competition law, governments try to ensure that the structure of the market is "competitive" by restricting the price-setting behaviour of firms.

Can we meaning- fully measure "market power?"

Operationally, it is difficult to determine the extent to which a firm in a particular industry has "market power." This is because what exactly constitutes an industry is a conceptually slippery matter. (footnote 7) For example, if an industry is defined as "Labatt's Blue," then a monopoly exists since there is only one producer of Blue (i.e., Labatt's). However, if we define the industry more broadly as "beer," then clearly Labatt's has less market power than before because there are other breweries such as Molson, Budweiser, and Foster's who compete with Labatt's. If we define the industry even more broadly as "liquor," then the industry becomes extremely competitive, for now we must include wine and spirits. The point is that how much market power a particular firm has depends on how one defines the industry, and the broader the definition used, the less market power any particular firm will have. Because it is not clear where to draw the line, the very definition of market power is suspect. This calls into question the ability of public policy to remedy the "problems" caused by market power.

But suppose, for the sake of argument, that we can define what constitutes an industry, and by extension, we can measure the market power of particular firms. Does it therefore follow that the government ought to intervene in order to alleviate the inefficiencies arising from imperfectly competitive markets? The answer to this is "not necessarily." What follows is two reasons why government intervention may not be desirable.

Contestable markets and technological change

The first reason is this: the number of firms in a particular industry does not, by itself, determine the behaviour of firms in that industry. According to Harold Demsetz and William Baumol, a monopolistic firm can be induced to behave "as if" it is a competitive one if there is a threat that other firms will enter the market. (footnote 8) The key to understanding this kind of market—called a "contestable market" —is to note that what determines whether or not a firm enters an industry is the presence of profits. For instance, if a monopolist brewery is making positive profits (i.e. is charging more than $1 per beer), there is an incentive for other firms to enter the industry. When other firms do enter, output increases, prices are reduced, and profits eroded. The threat of entry may deter a monopolistic brewery from setting its price above $1. Hence, the fact that only one firm produces beer is not, in itself, a reason to believe that it will be producing the monopoly level of output. Indeed, Demsetz himself writes that "no good theoretical link has been forged between the structure of [an] industry and the degree to which competitive pricing prevails, because no good explanation has been provided for how present and potential rivals are kept from competing without some governmentally provided restrictions on competitive activities." (footnote 9)

Another reason why government intervention may be undesirable has to do with the dynamic nature of the marketplace and the fact that technology always changes as firms innovate in search of new methods of production and new products. If technology is always changing, then what constitutes a monopoly today need not be a monopoly in the future. (footnote 10) The market power that firms possess today can be eroded by technological progress and the appearance of new products. An example of this is cable television. In the past, cable TV was characterized as a natural monopoly. At any given place, there could only exist one cable company because it was more efficient for a single cable company to serve a region than for several cable companies to do the same. Hence, regulation was set up to control the rate schedule for cable TV. However, with the development of satellite technology and fibre optics, the monopoly power of cable companies has eroded. Regulation governing the rate structure for cable TV may be inappropriate now that there are alternatives to it. Competition law and regulations that are set up to rectify market failure under a given technological structure can quickly become outdated in an age of rapid technological progress. Indeed, the presence of such regulations may impede the development of new technologies by "freezing in" a particular industrial structure. Hence, the rationale for government regulation to reduce the market power of firms is greatly weakened when we recognize the dynamic nature of the marketplace.

Footnotes

1. Adam Smith (1776, 1904), The Wealth of Nations, New York: G.P. Putnam's Sons.  Back to paragraph 1
2. Alan Feldman (1980), Welfare Economics and Social Choice Theory, Boston: Kluwer Academic Publishers. Back to paragraph 1
3. This is called the "First Theorem of Welfare Economics." See Feldman (1980). Back to paragraph 1
4. For a classic discussion of market failure see Francis Bator (1958), "The Anatomy of Market Failure," Quarterly Journal of Economics, 72:351-79. Back to paragraph 2
5. We have avoided answering the more fundamental question as to why only one producer may come to dominate the market. Usually, it is argued that economies of scale—a situation where the average cost of production falls as total output rises—can lead to a monopoly situation if these economies of scale are large relative to total market demand. Back to paragraph 6
6. William J. Baumol (1965), Welfare Economics and the Theory of the State, Cambridge: Harvard University Press. Back to paragraph 8
7. See Donald Armstrong (1990), "My Lady of the Law Is No Economist: My Lady Competition Law Is No Lady," and Herbert Hovenkamp, "The Measurement of Market Power: Policy and Science," in F. Mathewson, M. Trebilcock, and M. Walker, eds., The Law and Economics of Competition Policy, Vancouver: The Fraser Institute. Back to paragraph 12
8. See Harold Demsetz (1968), "Why Regulate Utilities?" Journal of Law and Economics, 2: 55-65; W.J. Baumol, J. Panzar, and R. Willig (1981), Contestable Markets and the Theory of Industry Structure, New York: Harcourt Brace Jovanovich. Back to paragraph 14
9. Harold Demsetz (1974), "Two Systems of Belief About Monopoly," in H.J. Goldschmid, H.M. Mann, and J.F. Weston, eds., Industrial Concentration: The New Learning, Toronto: Little, Brown and Company, p. 166-67. Back to paragraph 14
10. See Reuven Brenner (1990), "Market Power: Innovations and Anti-Trust," in F. Mathewson, M. Trebilcock, and M. Walker, eds., The Law and Economics of Competition Policy, Vancouver: The Fraser Institute. Back to paragraph 15

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