Market Power
What is Market Power?
Market power is a firm's ability to raise price above marginal cost without losing all of its buyers, which comes from facing a downward-sloping demand curve.
A firm with no market power is a price taker: its demand curve is flat at the market price, and raising price by a cent loses every customer. A firm with market power faces a downward-sloping demand curve, so it can charge more and keep most of its buyers, though it must accept selling fewer units. The power comes from barriers to entry, a differentiated product, control of a scarce input, patents, network effects, or simply having few rivals. The cost to society is that price sits above marginal cost, so output stops short of the efficient quantity and deadweight loss appears. Market power is a matter of degree rather than a category: monopoly is the extreme case, but a corner shop, a branded cereal and a neighborhood restaurant each hold a little of it.
Market Power: a worked example
A specialty bike maker sells a frame for $400 when building one more costs $250. Its Lerner index is (400 - 250) ÷ 400 = 150 ÷ 400 = 0.375, so 37.5% of the price is markup. A wheat farm selling at the market price of $250 with a marginal cost of $250 scores (250 - 250) ÷ 250 = 0, the price-taker result. The bike maker can go to $420 and lose only some buyers, while the farm that asks $255 sells nothing at all, because buyers have identical wheat available at $250.
The mistake students make with market power
Students equate market power with a large market share or with earning profit, and neither is the definition. Market power is the gap between price and marginal cost, so a firm holding most of an easily entered market may have very little of it, and a firm with real market power can still post a loss if its average total cost sits above the price it charges. Share is evidence; the price-cost margin is the thing itself.
Market Power questions
How is market power measured?
Market power is measured most directly by the Lerner index, the gap between price and marginal cost expressed as a share of price. Because marginal cost is hard to observe from outside a firm, regulators often fall back on market shares, concentration ratios and the Herfindahl-Hirschman Index, which describe structure rather than pricing.
What gives a firm market power?
A firm gains market power from anything that stops buyers switching to an identical cheaper alternative: barriers to entry, a differentiated or branded product, patents, control of a scarce input, network effects and high switching costs. The common thread is that its demand curve slopes down instead of lying flat.
Is market power always bad for society?
Market power always creates some deadweight loss, because a price above marginal cost blocks trades that both sides would have gained from. It can still be worth allowing when the profit is the reward for inventing the product in the first place, which is the reasoning behind patents, or when producing at large scale genuinely lowers costs.
Formula / Example
This is the live Monopoly sandbox. Drag the curves, or open the full version.
Related terms
Common comparisons
Get AP Econ exam tips in your inbox
Occasional emails with study tips, new interactive graphs, and exam-season reminders. Free, no spam.
No spam. Unsubscribe anytime. Read our privacy policy.
Keep track of what you have studied
A free EconLearn account adds progress tracking, your quiz history, and achievements. Studying here is free either way, and there is nothing to pay for as a student.
Create a free accountAlready have one? Sign in
Last updated