Model Answer
0 min readIntroduction
Monopoly power refers to the ability of a firm to profitably raise prices above competitive levels for a sustained period. It arises when a firm faces a significantly downward-sloping demand curve, indicating limited competitive pressure. Assessing monopoly power is crucial for competition policy and regulatory interventions. Several measures are employed to determine the extent to which a firm can exercise such power, ranging from traditional market share analysis to more sophisticated econometric techniques. These measures help authorities identify potentially anti-competitive behavior and ensure market efficiency.
Measures for Assessing Monopoly Power
Several metrics are used to evaluate the extent of monopoly power a firm holds. These can be broadly categorized as follows:
1. Concentration Ratio (CRn)
- Definition: The combined market share of the ‘n’ largest firms in an industry. For example, CR4 represents the market share of the four largest firms.
- Interpretation: A high CRn suggests a concentrated market, potentially indicating monopoly or oligopoly power.
- Limitations: Doesn’t account for the distribution of market share among the remaining firms or the geographic scope of the market.
2. Herfindahl-Hirschman Index (HHI)
- Formula: HHI = Σ (Si)^2, where Si is the market share of firm i, expressed as a percentage.
- Interpretation: HHI ranges from 0 to 10,000.
- Below 1,500: Unconcentrated market
- Between 1,500 and 2,500: Moderately concentrated market
- Above 2,500: Highly concentrated market
- Advantages: Gives more weight to firms with larger market shares.
3. Lerner Index
- Formula: L = (P - MC) / P, where P is price and MC is marginal cost.
- Interpretation: Measures the firm’s ability to set price above marginal cost. A higher Lerner Index indicates greater monopoly power.
- Challenges: Requires accurate estimation of marginal cost, which can be difficult in practice.
4. Output Elasticity of Demand
- Concept: Measures the responsiveness of quantity demanded to a change in price.
- Relationship to Monopoly Power: Firms with more monopoly power face more inelastic demand curves (less responsive to price changes).
- Estimation: Econometric techniques are used to estimate the price elasticity of demand.
5. Barriers to Entry
High barriers to entry protect existing firms from competition, allowing them to maintain monopoly power. These barriers can be:
- Legal Barriers: Patents, copyrights, licenses. Example: Pharmaceutical companies relying on patent protection.
- Economic Barriers: High start-up costs, economies of scale, control of essential resources. Example: The railway industry requiring massive capital investment.
- Strategic Barriers: Predatory pricing, aggressive advertising.
6. Cross-Price Elasticity of Demand
If a firm has monopoly power, the cross-price elasticity of demand between its product and other products will be low, indicating limited substitutability.
| Measure | Description | Advantages | Disadvantages |
|---|---|---|---|
| Concentration Ratio | Combined market share of largest firms | Simple to calculate | Ignores market share distribution |
| HHI | Sum of squared market shares | Weights larger firms more heavily | Requires accurate market share data |
| Lerner Index | (P-MC)/P | Directly measures price-cost margin | Difficult to estimate MC |
Conclusion
Assessing monopoly power is a complex undertaking, requiring the application of multiple measures. While concentration ratios and the HHI provide a snapshot of market structure, the Lerner Index and output elasticity offer insights into pricing behavior and demand responsiveness. Crucially, evaluating barriers to entry provides a forward-looking perspective on the sustainability of market power. A holistic approach, combining these measures, is essential for effective competition policy and ensuring consumer welfare.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.