Market Power - Why businesses charge more

[MUSIC] You're listening to Think Like an Economist, a Himalaya Learning Production. For exclusive content like bonus episodes and supplemental materials for this podcast and others like it, go to Himalaya.com/econ and enter promo code EconECON, a checkout to get your first 14 days free. It's time to think like an economist. [MUSIC] NAS, what would you think if I told you that sometimes the corner store that's just a short walk from your house and has opened 24 hours a day and has only a small range of items? What would you think if I told you that was more powerful than the humongous supermarket that sells thousands of products but is a 10 minute drive away? Justin, you know I'd be delighted. I love small businesses but how can the small shop be more powerful than a massive supermarket which has so many options? Well, let's say it's nearly midnight and you're having a party and you run out of beer. Your problem is that the supermarket is closed or perhaps it's not safe for you to drive there after a few drinks. But you can still walk to the corner store and get something. That's cool but still how does this make the all night corner store powerful? The all night corner store can probably get away with charging a bit more for beer than the massive supermarket. We'd say that the all night corner store has some market power when it comes to the market for late night drinks. And market power is the topic of today's think like an economist with me Betsy Stevenson. And I'm Justin Woffers. We're here to teach you the economic super tools to transform your decision making and your life. Nestra and Tevacoli Fahr joins us. So this is fun. I like that this small late night store is powerful but let's get down to basics. What is market power? Well market power is the ability to charge higher prices without losing many sales to competing businesses. Can we stick to our late night party example for a second? How does this play out? Well, let's say six pack of beers is eight dollars at the supermarket. The corner store may be able to charge twelve dollars for that same six pack of beer and not worry too much about losing you as a customer despite that higher price. This is because they know that this organized party has don't have another option late at night and are probably willing to pay a bit more for beer. Maybe it was a well-attended party rather than a disorganized host. Well that's true but either way the all night corner store can charge a little more knowing you're not going to head to a competitor on your midnight beer run. Now we're introducing a really important concept here because so far our analysis of supply decisions has only emphasized the seller's marginal costs but suddenly we're talking about a corner store raising its price a bit higher than that. It can do this because it has market power. Okay so first is it possible to not have any market power at all? Yes, when there are tons of buyers and sellers of an identical good then none of them have any market power. We call this perfect competition. A classic case is if you're selling wheat into the global market. There are zillions of wheat farmers and zillions of buyers from all around the world. I checked markets for the price of wheat this morning and it's currently trading two hundred and twelve dollars a ton. Now if you're a wheat farmer who tries to charge more even just a dollar more you'd get no customers and sell no wheat because there are thousands of other wheat sellers that a buyer can go to instead it will be charging less than you are. This means that all wheat farmers will likely end up charging the exact same price for a ton of wheat because if they charge even just a dollar more then buyers will just go to one of the countless other farmers instead. And at the equilibrium price of two hundred and twelve dollars a ton supply equals demand which means that farmers can already sell all the wheat they produce so there's no point cutting their price either. That's why in perfect competition each farm will be what we call a price taker because they take the equilibrium price set by the market and they just follow it. So in a perfectly competitive market you have many competitors selling an identical product and so they'll all end up charging the same price. Yep wheat farmers don't spend much time thinking about what price to charge. They have to sell their crop and they look at the current price to see what they'll get for it. But while perfect competition is common in economics textbooks and in commodity markets like wheat outside of agriculture it's incredibly rare in the real world. I personally find extremes are really helpful so what's the opposite of perfect competition? I'm guessing this could be when there's no competitors and there's a single business which can basically do what it wants. Sort of. The other extreme from perfect competition is a market that's a monopoly. So there's only one seller. They don't need to worry that if they charge a bit more they'll lose customers to arrive all. Yes remember that in the past we talked about farmer bro Martin Shrekreli. I do he's awful he's that guy who majorly increased the price of this life saving drug. Yes that's who I'm talking about. He was the CEO of a pharmaceutical company and a few years ago he increased the price of the life saving drug daraprim by more than 5,000% in a single day. The price went from $13.50 a tablet to $750 a tablet which is just outrageous. His company had a monopoly when it came to the market for daraprim so you didn't have another option to buy that drug from someone else. There was literally no other seller. So Shrekreli could increase the price of daraprim and not worry too much about losing customers to rivals because there weren't any rivals. But surely way fewer people will buy daraprim if it's $750 a tablet compared to $13.50. I mean at $750 a lot of people aren't going to be able to afford it anymore. That's true and it's an important point because it means that even a monopolist faces limits on the price they can charge. Their concern isn't losing sales to a competitor but rather that people might choose to do without instead. But Shrekreli figured that even if fewer people would buy daraprim at $750 a pop enough people would buy it that it would boost his bottom line. That was profitable to him but it was terrible for his customers who either had to cough up all that extra money or go without. This bad outcome was possible because Shrekreli had a lot of market power. We've looked at these extreme examples. These being having no market power if you're in a perfectly competitive market to having a lot of market power if you're a monopoly. Yes. So now let's turn to the fuzzy middle where most businesses lie. So if you have some market power you can raise prices a bit. You'll lose some customers to your rivals but you won't lose all your customers. And having some market power allows you to set a price that's higher than your marginal cost. So in our early example with the late night corner store they can charge a little more for beer. They'll probably lose some business to stores which charge less money for beer but which aren't open all night and the corner store is still going to keep their late night customers. That's right. Disorganized host of successful parties are still going to buy their price here beer. So if we don't have perfect competition I'm guessing we have imperfect competition and you're saying that most businesses have some market power. Now what does this mean in practice? Hey I said most businesses have some market power so let's experiment. You pick an example. I spy that we're all wearing eye glasses right now so I'm guessing that glasses are an essential product that the three of us all need. Is there somewhere we can go with this? Let's do it. Now let's say that you actually own an optician shop and your shop does glasses repairs. You have one competitor and there are 15 minute walk from your shop. In this case you have some market power. Oh my goodness Naz I've just broken my glasses and I need them fixed urgently. Now I need my glasses and your shop is closer to me than your rival. I don't have time to go walking around between opticians to see who can give me a better price so I'll just walk into your shop and pay you to get the job done. You have some market power. Justin doesn't have the time to find out if there's a cheaper option and you're the closest place he can go for this urgent repair job. Well he might not even be able to go somewhere else. I don't know about you Justin but I can barely see where I'm going if I don't have my glasses on. Yeah so if someone relies on their glasses they'll probably go to the closest place that they can to get them fixed ASAP. When you have some market power you can raise your prices a little and many of your customers will still keep coming to you. But Naz this is a careful balancing act. If you raise the cost of your repairs you will lose some customers. Say I have a spare pair of glasses in my office or my site isn't so bad and I can cope for a few days without my glasses. Well then I can spend some time scouting around for cheaper places to get my glasses repaired including checking out that rival of yours who's 15 minutes away. Your shop faces a trade-off when you'd raise prices. Your profit is your profit margin or markup on each unit multiplied by the number of sales you make. So raising your price means you'll make more profit on each repair but you'll also have the balances with how many fewer customers you'll get paying you money for your repair service. The key trade-off most businesses face is that raising their price will boost their profit margin on each sale they make but reduce the number of sales they have. The amount of market power you have determines how sharp that trade-off is. If you lack market power you need to keep your prices close to your marginal cost or you will scare off way too many customers. However if you're like Martin Shekreli with a lot of market power you can mark up your prices a lot. I'm hearing that market power seems really important for determining how real businesses set their prices. So with my optician's shop what impacts my market power? Well the first factor is the number of competitors you have. Currently there's one other optician a 15 minute walk away from your shop. If another one opens and is much closer to your shop then your customers have more options and you'll have less market power and less scope to raise the price of your repair services. Can I increase my market power? Say if I make my service stand out somehow so that it's unique or it's different from my rivals? Absolutely and that leads to the second factor that determines your market power. Economists use the word product differentiation to describe your efforts to distinguish your products from others. An example could be that you use really state-of-the-out equipment or techniques which mean that your repair is just better than your rivals. You could then charge more without worrying about losing customers to your rivals who do a subpar job. Smart business owners tend to understand this point really well by making your products stand out so that it's somehow unique and unique in a way that your customers value you can charge more and not worry about losing too many sales and this is why marketing can be really important for some types of products. So there are two factors that go into how much market power I have, how many rivals I have and how unique my product is and the more market power I have the more I can charge what I want without worrying too much about losing too many customers. Though Justin you said that it's a balancing act because charging more will mean fewer customers so I need to see how this impacts my overall profits. That's right and so we're going to need to figure out how to handle that balancing act. It's really interesting that if you have some market power you can have some say in what you charge that it's not all determined by the market. What do businesses do on a practical level to figure out what price they can charge? Businesses first try to figure out the demand curve for their product. So now let's stick with your optician shop. You probably try out different prices using sales to see how many people will pay for your service at each price. This way you can plot a demand curve with your results. And if I raise my price I'm going to get fewer customers. That's right but the real question is how many customers you'll lose and that depends on your market power. And this is where we need to introduce an important idea. Now remember the marginal principle. I do. We have to break decisions up into smaller decisions which ask how many? You bet which is why instead of asking how many repairs should I do you'll ask should I sell one more repair and I know Nas that you're itching to apply the cost benefit principle to this decision. Yeah I do want to make one more sale if the benefit which is the extra revenue from that sale exceeds the extra costs involved and I remember the extra costs of producing one more unit is called my marginal cost. Yes and the extra revenue you get from that extra sale is called your marginal revenue. So you want to make one more sale as long as the marginal revenue exceeds the marginal costs. We call this the rational rule for sellers. The idea that you should keep selling as long as your marginal revenue covers your marginal costs. Follow that rule and it says you'll keep producing until your marginal revenue is equal to your marginal costs. So calculating your marginal revenue is critically important to choosing the quantity you produce and it's easy enough to do with the spreadsheet. Most businesses know that if they want to make more sales they'll usually have to drop their price a bit and remember if you lower your price it's going to apply to all your customers. So your marginal revenue reflects both the extra money you'll get from that extra sale and all the money you'll for go from having to cut your price a bit. Again you'll choose the quantity you want to sell by focusing on your marginal revenue and keep producing until it's equal to your marginal cost. But when it comes to setting your price if you've got market power you want to charge more than your marginal cost. And so you'll go to all the data you collected for your demand curve and charge the highest price you can get away with and still sell that quantity. In the more market power you have the more you'll be able to get away with charging a price that's higher than your marginal cost. To make sure we've really understood this you're saying that the higher my market power the more I can raise my prices. That's it Nez. A businesses market power determines how much it'll be able to charge a markup above its marginal costs. Market power is so key that business schools are full of classes on marketing and strategy the teach would be entrepreneurs how they might increase their market power. Market power sounds like it's really great for the seller but what about if you're a buyer? It can be really problematic for consumers. For example I recently broke my iPhone and had to get a new phone. Now Apple have done a great job with product differentiation. To the point that when you buy an app it will only work on an iPhone. I've spent tons of money on apps so I felt like Apple was almost forcing me to buy another iPhone even though Android phones can be much cheaper. Justin you're saying that Apple's market power isn't great for you. It's not. Apple figures that it can get away with raising its prices and it won't lose too many customers. In fact the original iPhone cost only $500 and the latest versions cost more than double that. The problem for buyers is that market power usually leads to higher prices. People get frustrated because market power means sellers get rich and buyers lose out but economists focus on the fact that the real loss to society as a whole comes from the fact that higher prices mean fewer sales and therefore fewer people can benefit from buying and using the product. Remember the example with Martin Shekreli and Dara Prim? He sold fewer tablets at $750. A lot of people who could have benefited from Dara Prim just couldn't afford it anymore and that created a lot of unnecessary suffering. Betsy Justin it's time to summarize. I think I heard you say that in the real world it's all about businesses who have some market power. Yes and the big lesson is that when businesses have market power they can charge a price that's higher than their marginal cost. The more market power they have the larger the market. And businesses can shape their market power. Remember your market power depends on how many competitors you have and how different or unique your products are. Savvy executives are always trying to tweak both of these factors. And this can create deeper problems. Business executives know they can earn more profits if they can accumulate more market power so they'll spend their time and energy and money working to increase their market power. They'll devise all sorts of marketing strategies to make you think that Pepsi is really different from Coke or to try to get rid of their rivals or prevent new rivals from ever getting past the start-up stage. This is a problem because we know that competition leads to good outcomes. But this logic says that businesses will always be working to accumulate market power which weakens the force of competition. So competition is good for society but businesses try to destroy competition. This is what I think is a really important idea. A lot of people who believe that markets produce good outcomes are really thinking about the virtues of competition but businesses are often trying to undermine competition. So being pro-market or pro-competition can be really different from being pro-business. A lot of pro-market policies might actually be about preventing businesses from doing whatever they want. So my homework assignment for our listeners as they go about their lives this week is to listen to all the different arguments that are being made by businesses or politicians and to ask yourself are they lobbying for changes that are pro-market or for changes that are pro-business? Answering this question is important for thinking about whether society as a whole will benefit. Betsy, Justin, thanks so much. These are some really big questions looking forward to hearing more next week. It's great talking with you as always, NAS. And we're happy to have you as our monopolist on this podcast, NAS. My opticians are monopoly. Can't see where you're going without me. 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