Last week, my ECONS101 class covered market power and competition (as part of a larger topic introducing some of the principles of firm behaviour). This coming week, we'll be covering elasticity, which is closely related and builds on the key ideas of firm behaviour.
Market power is the ability of a seller (or sometimes a buyer) to influence market prices. The greater the amount of market power the seller (or buyer) has, the more they can raise their price above marginal cost. That is, sellers with greater market power will have a higher mark-up (which is the difference between price and marginal cost).
How do firms get market power? There are several ways, but the greatest contributor to market power is the extent of competition in the market. When firms face a lot of competition in their market, they will compete vigorously on price, and so their mark-up will be lower. When firms face less competition in their market, they don't have to compete on price to the same degree, and so their mark-up will be higher.
Another way of seeing this is to consider the price elasticity of demand. When there are many substitutes for a good, the demand for that good will be more elastic. If the seller raises their price, many of their consumers will buy (one of the many) substitutes instead (because those substitutes are now relatively cheaper). So, firms selling a good that has many substitutes (a good that has more elastic demand) will have a lower mark-up. And if a firm's good has many substitutes, that means a lot of competition.
On the other hand, when there are few substitutes for a good, the demand for that good will be less elastic. If the seller raises their price, few of their consumers will buy substitutes instead (because there are few substitutes available). So, firms selling a good that has few substitutes (a good that has less elastic demand) will have a higher mark-up. And if a firm's good has few substitutes, that means less competition.
Taking all of this together, when a market loses one or more of the competitors, and competition reduces, we should expect to see an increase in prices. A clear example of this is what happened when the Australian regional airlines Bonza and Rex closed down last year. As Doug Drury (Central Queensland University) wrote in The Conversation last November:
In 2024 alone, we’ve seen the high-profile collapse of both Bonza and Rex, airlines that once ignited hopes for much greater competition in the sector. Now, we’re beginning to see the predictable effects of their exit.
According to a quarterly report released on Tuesday by the Australian Competition and Consumer Commission (ACCC), domestic airfares on major city routes increased by 13.3% to September after Rex Airlines halted its capital city services at the end of July.
The collapse of the two low-cost domestic airlines in Australia reduced competition on domestic routes. Unsurprisingly, the lower competition means more market power for the remaining airlines, Qantas and Jetstar. And that greater market power has translated into higher prices for domestic airfares in Australia.
The importance of competition for prices cannot be overstated. As one other example, a lack of competition has been implicated in the perceived high prices in New Zealand supermarkets (a point I will come back to in my next post, but this is a topic I have written about before here). The Commerce Commission is understandably concerned whenever there is a lack of competition, and whenever competition will be substantially reduced by the merger of two or more firms (for example, see here and here about the recently rejected Foodstuffs supermarket merger). When there is a lack of competition, sellers have more market power, demand will be less elastic, and for both of those reasons we can expect prices to be higher.
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