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Measuring Market Power

The approach to determining market power indicators is based on

comparing real markets with perfect competition. As far as the market approaches the ideal of free competition, one can judge by the behavior of firms in terms of price and cost: the more the price set by the firm deviates from marginal cost, the more market power the firm has and the more the market becomes imperfect.

Most indicators of market power explicitly or implicitly evaluate either the magnitude of economic profit or the difference between price and marginal cost.

Economic profit - the difference between total income and costs, which include imputed (additional to accounting, unaccounted for in accounting) costs of the manufacturer, lost opportunities. Net economic

profit is calculated as the difference between the estimated accounting and normal profit.

Accounting profit - the total gross profit of the enterprise at the expense of all sources, minus the payment for resources and interest for short-term loans. Accounting profit is found by determining the difference between total income and cash costs, calculated according to accounting documents without taking into account the documented costs of the enterprise itself.

Normal profit - the level of profit necessary and sufficient to

so that the resources involved in the production of a particular product are not allowed for other purposes. Exceeding normal profits attracts additional resources to the industry and creates conditions for new companies to gain access to the industry. At a profit level below normal, part of the resources is withdrawn from the industry in the expectation of more favorable opportunities for the production of other goods.

Normal profit is an important component of perfect competition,

in which in the long run it is possible to receive only normal profit.

Marginal cost - additional production costs required

for the production of an additional unit of production.

The following indicators are used to measure the market power of a firm: the Bane index (rate of economic profit), the Lerner index, the Tobin coefficient, the Papandreoux index.

The Bane Index shows economic profit per dollar of equity invested. It is defined as:

When calculating and using the Bane index, a number of difficulties arise:

• in assessing the value of capital assets and depreciation;

• in assessing the costs of intangible assets (primarily advertising and research and development), which are similar to capital costs in terms of influence on the behavior of the company (they are made in one year, and can bring in income for several years);

• in accounting for income taxes and taking into account the riskiness of capital investments.

Lerner index - the use of this index to assess the degree of monopoly power was proposed in 1934 by the economist Abba

Lerner:

L = (P - MS) / P, where

L is an index showing the degree of monopoly power;

P is the price;

MS - marginal cost.

It is assumed that with the growth of monopolism, the gap between the price of a product and the marginal cost of its production increases. The value of the Lerner index is always between 0 and 1. With perfect competition, it is 0.

Price and marginal cost are related to each other through price elasticity of demand. The price elasticity of demand limits the excess of prices over marginal costs available to firms operating in markets with imperfect competition.
If demand is inelastic, firms can increase the price compared to

costs more than in the conditions of elastic demand. In addition, the lower the elasticity of demand, the easier it is for a dominant firm to simultaneously limit entry into the industry and make economic profit.

The Tobin coefficient is an indicator of market power characterizing a relative assessment of the state of a firm by the market in comparison with an internal assessment of the firm itself.

The Tobin coefficient relates the market value of a firm (the measured market price of its shares and bonds) with the replacement value of its assets:

q = P / C, where:



P - the market value of the assets of the company;

C is the replacement cost of the assets of the company, equal to the amount of expenses necessary to acquire the assets of the company at current prices.

If the stock market estimates the company more than the replacement cost of its assets, that is, if P> C (q> 1), then this means that the company receives additional profit. The actual or expected level of profit in the industry is higher than necessary to keep the firm in the industry.

Numerous studies have established that the q coefficient is, on average, quite stable over time, and firms with a high value of it usually have unique factors of production or produce unique goods, i.e., monopolistic rents are typical for these firms. Firms with small q values ​​operate in competitive or regulated industries.

The Papandreoux Monopoly Power Index is based on the concept of cross elasticity of demand. A prerequisite for the exercise of monopoly power is the weak influence on the sales volume of a given firm of the prices of other firms of the same market.

However, the indicator of cross elasticity of demand alone cannot serve as an indicator of monopoly power, since its value depends on two factors affecting monopoly power: the number of firms in the market and the level of substitution of goods of the seller in question and goods of other firms. An increase in the number of firms in the market leads to a decrease in their interdependence and a corresponding decrease in the indicator of cross elasticity of residual demand. In the perfect competition market, the elasticity of demand for a firm’s product tends to zero. The decrease in the interchangeability of the goods of the company and the goods of other sellers as a result of the deepening of product differentiation leads to a decrease in the elasticity of demand. But in the same way, the departure of large sellers from the market where the company under consideration operates, will lead to a decrease in its dependence on price decisions of other companies, to a decrease in the elasticity of residual demand. By definition of a pure monopoly, a firm's product should not have close substitutes. Consequently, if the market share of the company tends to unity, that is, the market structure approaches monopoly, then the elasticity of demand (approaching market demand) will tend to zero.

In addition, the influence of the pricing policy of other firms on the market on the sales volume of the firm in question depends on the limited capacity of other firms, on how much they can actually increase their own sales and thereby reduce the market share of the firm.

To overcome this problem, A. Papandreou in 1949 proposed the so-called penetration coefficient, which shows how many percent the firm's sales will change when the competitor's price changes by one percent.
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