Industrial Organization

9. Market power

2021/22, 1st Semester

Margarida Catalão Lopes

 Market power
• Market power = capacity to set (and
mantain) price above marginal cost, which is
the level that would prevail under
competition.
• Danger: abuse of dominant position
• Lack of competition opens the door to
beneficial public intervention.

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 Market power
• The degree of market power depends on
– demand elasticity
– market concentration
– how collusive is firms’ behavior

• Market power is measured by the Lerner

index: L=(P-MC)/P

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 Market power
“When a firm has market power, how will it
behave? How does its behavior affect the
firm’s suppliers, customers, and
competitors?”
(Extracted from: Scientific Background on the Sveriges Riksbank Prize in
Economic Sciences in Memory of Alfred Nobel 2014, JEAN TIROLE:
MARKET POWER AND REGULATION)

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 Market power
• For a monopolist with a single good,
L=1/e
• A monopolist with n goods chooses pi (i=1,2,…n) to
maximize

where p is a price vector.

FOC:

If total cost can be split into n costs,

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 Market power
After some algebraic manipulation we get
𝑝𝑖 −𝑐𝑖 1 𝑝𝑗 −𝑐𝑗 𝐷𝑗 𝜀𝑖𝑗
Li= = + σ𝑗≠𝑖
𝑝𝑖 𝜀𝑖𝑖 𝑅𝑖 𝜀𝑖𝑖
where eii is the (absolute value of the) direct
price elasticity, eij is the cross-price elasticity, 𝑐𝑗
is the marginal cost of producing good j, and
Ri=piDi (revenue associated with good i)

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 Market power
• Interpretation:
– if the monopolist is selling substitutes (eij>0), the
Lerner index for good i is above the value for the case
in which the monopolist is selling just one good,
because by raising the price of i’s product the
monopolist sells more in the other markets;
– if the monopolist is selling complements (eij <0), the
Lerner index for good i is below the value for the case
in which the monopolist is selling just one good,
because by raising the price of i’s product it sells less
also in the other markets.
• Now comment on the effect of 𝑅𝑖 , 𝑝𝑗 − 𝑐𝑗 and 𝐷𝑗
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 Market power
• The Lerner index of market power (Cowling-
Waterson formula), valid for any market structure:

L=H(1+g)/e

• It is clear from the formula that the degree of

market power depends on demand elasticity, market
concentration, and how collusive is firms’ behavior.

• The conjectural variation g: expectation of the rivals’

response to a change in the firm’s strategic variable.

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 Market power
• Value of g under several models:

– Bertrand: g= -1, hence L=0

– Cournot: g= 0, hence L=H/e
– Collusion: g= N-1, hence L=NH/e
– Monopoly: H=1, g= 0, hence L=1/e

• Other values for g: as g decreases (increases),

competition is intensified (softened).

• 0≤ L ≤1/e

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 Market power
L=H(1+g)/e

• All other things equal (ceteris paribus), the

greater the concentration (as measured by H),
the greater the market power.

• Ceteris paribus, the higher the demand elasticity,

the lower the market power.

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