This post originally appeared on The Finance Buff and was cited in the 208th edition of the Carnival of Personal Finance.
It is a common feeling among consumers that some firms charge “more than they should” for their products. Microsoft is a favorite example. What is the source of such price setting power? Many would respond: “supply and demand” or “monopolistic behavior.” In this post I dig a bit deeper.
In a prior post on the economic welfare of Google Reader I noted that in a perfectly competitive market economic welfare (of the classical sort) is maximized: the sum of the value to consumers above price paid and producer profit cannot be higher. A perfectly competitive market for a product requires, among other things, (1) barrier-free market participation and (2) no variation across producers in the product’s characteristics. Markets that come close to satisfying these requirements are rare and include those for agricultural commodities and those provided by stock exchanges. There are many traders of both grade 3 hard red wheat and Google equity. Anyone can participate in the exchanges in which futures contracts of the former and shares of the latter are traded. Properties of both are homogeneous.
The price of a good in a perfectly competitive market is the marginal cost of producing the good. This price is lower than it would be if either of the properties listed above were violated. The difference between the price under imperfect and perfect competition relative to marginal cost is known as the markup (source, p. 184). (Note that markup used here does not measure the amount by which retail price exceeds wholesale price. Imperfect competition leads to markups of the wholesale price itself.)
Thus, we can write
[Eqn. 1] market price = (marginal cost) x (1 + markup),
where markup is always nonnegative (and is zero under perfect competition). Since perfect competition is rare, markups are common; we pay them all the time. For example, for its Office product Microsoft receives much more than it would if competition for software were perfect. In Medicare, the market for stand alone prescription drug plans (PDPs) seems to be more competitive with lower markups than compared to the Medicare Advantage (MA) market.
Markups quantify “price setting power” or “market power.” The source of this power and the determinant of the size of the markup is the structure of consumer demand. To explore this further, consider a market for health insurance in which two firms, A and B, each offer a slightly different health insurance plan. Such a market has barriers to entry: insurance regulatory requirements, establishment of provider networks, among others. The products in the market are said to be “differentiated,” each plan is unique in some way (different benefits, costs, provider network, and so on). The conditions for perfect competition are violated. Markups will exist.
Suppose Eqn. 1 is the market price (premium) for plan A. With a bit of calculus and algebra well beyond the scope of this post (Hal Varian’s “conjectural variations”) one can show that the markup for plan A depends on two quantities: the proportional rates at which consumers reject plan A in favor of plan B as (1) plan A’s price increases, and (2) plan B’s price decreases. The first of these is known as plan A’s (own) price elasticity of demand. The second is the cross price elasticity of demand for plan A relative to price of plan B. Swapping A’s for B’s gives a similar set of elasticities for plan B. It is only sensible that own price elasticity is negative, indicating a plan’s enrollment decreases as its price increases. Because plan A and B are substitutes cross price elasticity is positive, indicating a plan’s enrollment decreases as its competitor’s price decreases. Price elasticities of demand encapsulate consumer preferences and patterns of substitution among products. They measure how much more (or less) of a product we would purchase when its price or that of substitutes for it (competitors) changes.
When studying a market with large numbers of products (e.g., breakfast cereals, automobiles), it is unwieldy to work with cross price elasticities between all product pairs. Clever techniques that relate elasticities to product characteristics have been developed for such circumstances (one source, another). Since the number of characteristics of principal importance to consumers can be much smaller than the number of products, this greatly simplifies analysis. (Consider automobiles, of which there are hundreds. How many product characteristics are important to you? Likely far fewer than 100. Maybe closer to 10.)
There is a beautiful circularity in all this. Price is a function of markup. In turn, markup is a function of consumer preferences with respect to substitutability. Substitutability patterns can be described in terms of characteristics of the products. Yet a product’s characteristics can be a function of the price the producer expects to receive for it. Consider an insurer designing a health insurance plan. If the insurer expects a high price (high markup) it might build in more generous benefits (product characteristics) than if it expected a low price. In the jargon of economics, price is endogenous in that it is determined simultaneously with other product characteristics. Fortunately, there are techniques for breaking the circularity problem to estimate elasticities free of the effects of bias due to endogeneity.
Of course, as consumers, we need not worry about the producer’s simultaneity problem in product design. Yet, because our collective patterns of demand and substitution drive markup and price, we play a key role in the process, one we don’t ordinarily consider. Each time you face the wall of breakfast cereals (or lot of cars or any other set of substitutable products), judging prices and characteristics, you’re voting with your wallet. When the prices adjust and your purchasing patterns with them you’ve just made a tiny contribution to the values of relevant cross price elasticities. So what’s the source of price setting power? In a sense, you are.
