Market Failure

Significance of market power

Businesses have many ways of acquiring and reinforcing their market power. Product differentiation, branding and some pricing strategies can help them to increase their market share and may play a part in enhancing market efficiency, especially when they encourage the use of new technologies. However, they may try to collaborate with competing businesses in ways that enable them to charge higher prices. This will reduce consumers’ spending power and lead to lower standards of living.

Similarly, large numbers of employees may belong to a trade union that encourages industrial action; it may act like a monopolist and become, effectively, a single seller of the appropriate labour. This can raise production costs and prices. Another kind of market power may occur when there are limited job choices available to those seeking work. They may receive very low pay because there is a monopsonist employer with considerable market power and few alternative jobs to apply for.

This part of the spec should enhance understanding of the fact that the model of perfect competition is in marked contrast to the markets in which anti-competitive practices distort the allocation of resources and standards of living are negatively affected.

Market Failure, figure 1

Implications on economic agents

There are many ways in which organisations can develop market power, which often has a negative effect on the efficient functioning of the market concerned. You should explore the way in which vested interests may take decisions that will increase profitability and the extent to which such decisions may run counter to the public interest. You must be aware that economies of scale and new technologies often lead to lower prices and new products, while simultaneously enhancing the market power of the producer.

Studying a natural monopoly too may highlight a situation where market power is inevitable but can be in the consumers’ interest if appropriately regulated. Governments can be affected by the market power of suppliers, for example when they are awarding defence contracts. Or by bilateral monopolies where both buyer and seller have market power, for example when the British Medical Association is negotiating pay with the NHS. The winner will be the side with the most powerful negotiating skills.

Revisiting forms of market power

Cartels, collusion, restrictive practices and tacit agreements

Collusion (overt or tacit?) means collaborating to take joint action, generally to reduce competition and exploit consumers.

Cartels are the economic agents involved.

Some industries are intensely competitive, with fierce rivalry and extensive choice.

Other are dominated by global oligopolies, thus there is the potential for collusion.

The extent of collusion depends on where the market is on the spectrum of competition.

Cartels may agree high prices and share higher profits than a competitive environment would allow.

Firms collude to exclude so they can take advantage of market power by acting to reduce competition.

Restrictive practices include:

  • Reducing supply and increasing prices

  • Market sharing – dividing up the market geographically

  • Price fixing (remember the milk price fixing scandal!?)

  • Artificial barriers to entry (e.g. ‘tied in sales’ of Coke fridges!)

  • ‘Bundling’ products also reduces competition – e.g. Microsoft and its IE software in the 90s…

All of these are anti-competitive practices. Once consumers have little real choice, higher prices will deter relatively few buyers due to lower PED as a result, thus revenue/profits increase.

Price leadership refers to a situation where prices and price changes established by a dominant firm, or a firm are usually accepted by others and which other firms in the industry adopt and follow.

We see examples of this with the major mortgage lenders and petrol retailers.

Put another way, firms agree to play a certain strategy without explicitly saying so (i.e. not overt/formal collusion)– with the ‘interdependent nature’ of oligopolies and price leadership playing their part.

Monopsony power

  • Every transaction has a buyer and a seller. Under a monopsony there is one buyer and many sellers in a market; thus suppliers get exploited.

  • The focus in market failure is often on supply, but buyers can also have market power – a monopsony.

  • In reality, a rarity. Closest thing we have is UK supermarkets and small farmers, with Tesco often criticised as the worst monopsonist!

  • Tesco ‘breached industry code’ in dealings with suppliers -

  • Watch 10 min of BBC documentary on Tesco to set the scene….from 13 min onwards…

__ Natural monopoly__

  • Competition would be wasteful with natural monopolies thus the sole supplier has market power.

  • Such as regional water suppliers. Arguably, the rail network. Corbyn certainly seems to think so!

  • To have multiple competing networks of gas and water pipes or railway tracks would be a wasteful duplication of resources.

  • Such industries were once in the public sector pre-Thatcher. In some countries they still are!

  • Example: Germany’s efficient train network. China’s ‘State-owned Enterprises’ are a big economic weakness, with 117 of them!

  • Private sector natural monopolies, such as UK water companies, will seek to minimise costs if they are profit maximisers, thus attaining productive efficiency. However without competitive forces, allocative efficiency is not guaranteed.

  • Water prices were the fastest growing index of the RPI for three decades after privatisation in the 80s.

Power in the labour market (refer to 3.5)

  • Monopoly and monopsony power can be found in labour markets.

  • The public sector employs a significant proportion of workers in many countries – often 30%-50% of the labour force.

  • As we saw in 3.5, professional associations and trade unions sometimes have monopoly power.

  • Such as Teacher’s unions in the UK and state schools and the BMA and the NHS.

  • The recent “junior doctors’ hours” conflict: the NHS has monopsony power and the BMA has monopoly power. Therefore the continued stand off produces a counterveilling power!

  • Reducing monopoly or monopsony power can lead to a better balance. However, if the limited power of the weaker side is reduced this can make markets less efficient or fair.

The implications of market failure on a consumer, business and governmental level

  • Where markets work efficiently, the invisible hand of market forces needs no government intervention. Competitive forces encourage firms to minimise costs – thus attaining productive efficiency. If the social benefit of the last unit made balance the social cost, there will be allocative efficiency.

  • However, resources are often allocated inefficiently and market failure (7 types: positive/negative externalities, public goods, labour immobility, asymmetric information, inequality, monopolies/lack of competition in a market & merit goods) occurs.

  • Consumers: exploited, pay high prices

  • Businesses: high prices, suppliers exploited. Extensive market power stops competing businesses as a barrier to entry (patents, EofS, new technologies & non-price competition all enhance their market power further!)

  • Government/society: Governments have market power (monopsonies in labour markets (teachers/doctors) and monopoloy power in public sector services (schools/hospitals)). If public sector provision is inadequate or goes beyond supplying efficient quantities, this is a market fail.

Market Failure, figure 1