Sources of market power
Learning goals
After this page, you can:
- Name and recognize the seven sources of market power — brand, network effects, switching costs, patents, scale, control of an input, and regulation — from a short business description.
- Explain the link to the markup: fewer close substitutes → less elastic demand → a larger markup; when a barrier falls, |ε| rises and the best price drops.
- Explain why digital platforms often charge one side nothing, and tell real evidence of market power from claims that are not evidence.
The idea
Two coffee shops on the same street charge almost the same. The office software on your laptop costs far more than the cost of one more copy, and your company pays for it every year. The coffee shop’s customers can walk next door. The software company’s customers would need to retrain a whole office to leave. Same idea, very different walls.
Market power is the ability to price above marginal cost. It lasts only as long as something keeps close substitutes away. Economists call these things barriers to entry. A useful picture is a castle moat: the markup sits in the middle, and the walls around it keep rivals from competing it away.
The seven walls.
- Brand — customers pay more for a name they trust, even when a look-alike exists.
- Network effects — the product is worth more when more people use it. A messaging app with all your friends beats a better app with none of them.
- Switching costs — leaving is costly: moving records, retraining staff, new equipment.
- Patents and intellectual property — the law blocks copies for a number of years.
- Scale (natural monopoly) — one firm can serve the whole market more cheaply than two can.
- Control of an input — the firm owns something rivals need, like the only nearby quarry.
- Regulation — a license, permit, or franchise lets only one or a few firms operate.
Why walls mean markups. Each wall removes close substitutes. With fewer substitutes, customers react less to a price rise, so demand is less elastic. From markup and elasticity, the best price is P = MC ÷ (1 − 1 ÷ |ε|). Lower |ε| → bigger markup. When a wall falls, the chain runs backward: |ε| rises, and the best price drops. Notice what does not change: the cost of serving one more customer. The markup shrinks only because customers now have somewhere else to go. Suppose a fixed-wireless company starts selling in Ridgeline Cable’s county. Ridgeline’s |ε| at the old price rises from 1.5 to about 3. Its best price falls from $75 to $37.50, even though its costs did not change.
Natural monopoly in numbers. A cable network has a large fixed cost: it costs the same to run whether 1,000 or 4,000 homes subscribe. One network spreads that cost over every home. Two networks each carry the full cost over half the homes. So the second network costs twice as much per home, and it rarely gets built. That is scale acting as a wall.
Platforms: why one side is often free. A platform connects two groups, such as diners and restaurants, or riders and drivers. Each side values the platform because of the other side. So a platform often charges one side nothing — or even pays it, with free delivery or sign-up bonuses — to attract the side that makes the other side willing to pay. A food-delivery app may charge diners no fee and charge restaurants a commission. The restaurants pay because the diners are there.
Evidence versus claims. For Playbook P5 you will rank your company’s top two walls. Use evidence, not claims.
- Claim: “We have a strong brand.” “We spend a lot on advertising.” “Everyone knows our logo.”
- Evidence: a price premium that holds (“our product sells at a 20% premium to store brands with the same ingredients, and our share did not fall”); high renewal rates; a patent with years left; a franchise agreement with a fixed term.
Then look for the risk: a patent that expires, a new technology, a regulator’s decision, or a cheaper substitute. The 10-K’s risk-factor section is a good place to find it.
No new formula. Best price: P = MC ÷ (1 − 1 ÷ |ε|) · Lerner = 1 ÷ |ε|
A wall falls → |ε| rises → Lerner falls → best price falls
Natural monopoly: fixed cost per household = F ÷ households served
Try it
Part A: the moat sorter. Ten short fictional businesses. Sort each one onto the wall that protects it.
- Tap a scenario card, then tap a wall. Read the feedback.
- Two of the cards have two walls. Find them.
- When you finish, name the top two walls around your own company.
Part B: the erosion slider. Move the slider from “only provider in the county” toward “fiber and wireless both available”.
- Start at |ε| = 1.5. What is the best price? How many cents of each dollar are markup?
- Press “A fixed-wireless rival arrives”. Did the price fall by half? Did the markup share?
- Push |ε| to 10. How close does the price get to marginal cost?
Worked example
Problem. What protects Ridgeline Cable’s (fictional) markup, and what happens when one wall falls? Marginal cost is $25 per subscriber; the network costs $35,000 a month to run; the county has 4,000 homes.
Step 1. Scale. One network serving all 4,000 homes carries 35,000 ÷ 4,000 = $8.75 of fixed cost per home. Two rival networks splitting the county carry 35,000 ÷ 2,000 = $17.50 per home each. A second network rarely gets built.
Step 2. Regulation and switching costs. The county franchise agreement sets the rules for using poles and roads. Changing providers takes an installation visit and new equipment.
Step 3. The threat. A fixed-wireless company starts selling in the county. Customers now have a substitute. Ridgeline’s |ε| at the old price rises from 1.5 to about 3.
Step 4. The new best price. Before: P = 25 ÷ (1 − 1/1.5) = 25 ÷ (1/3) = $75. After: P = 25 ÷ (1 − 1/3) = 25 ÷ (2/3) = $37.50. The Lerner index falls from 0.67 to 0.33. Note: the price does not fall to $50. The markup share halves, not the markup in dollars. If |ε| reached 5, the price would be 25 ÷ 0.8 = $31.25.
Step 5. Evidence. For P5, “we have a strong network” is a claim. “We are the only wired provider in the county, under a franchise agreement with years left” is evidence. “A fixed-wireless rival launched last year” is the risk.
Check yourself
A rural internet network costs $35,000 a month to run however many homes it serves, and the county has 4,000 homes. One network carries $8.75 of fixed cost per home; two rival networks would carry $17.50 each. This source of market power is:
When one firm can serve a market more cheaply than two, scale itself keeps rivals out.
A client would need to retrain 200 employees and move ten years of records to leave its accounting-software vendor. The vendor’s market power comes mainly from:
Switching costs make demand less elastic: customers stay even when a rival cuts its price.
Each user of a messaging app finds it more useful the more of their friends are on it. A new app with better features struggles to win users. The barrier is:
Network effects make the largest network the most valuable, which keeps rivals small.
A cable operator with marginal cost $25 faces |ε| = 1.5 and prices at $75. A fixed-wireless rival arrives and its |ε| rises to 3. Using the Lerner rule, its new profit-maximizing price is about:
A falling barrier raises |ε|, and P = MC ÷ (1 − 1/|ε|) drops.
For Playbook P5 you want evidence that a company’s brand is a source of market power. Which is the best evidence?
Evidence of market power is a price above cost that holds — not effort or fame.
Video
Video coming soon.