This post is inspired by some comments at this EconLog post by David Henderson.
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Money prices set by market forces play a uniquely important role in directing and disciplining economic actions. This role is both so central to an economy’s health, as well as so deeply ignored or misunderstood by the vast majority of people, that economics, as a discipline, has devoted huge amounts of effort to the task of explaining the formation of prices and to explaining prices’ role. Indeed, another, now a bit old-fashioned, name for microeconomics is “price theory” – a name that reveals the importance that economists (correctly) attach to the role of prices in a market economy.
Of course, money prices are not all that matter. Product quality, input quality, product and input selection, and information (among other non-price phenomena) also matter. Consumer and producer decisions, while heavily influenced by relative money prices, are not influenced exclusively by such prices. As I tell my students, a beat-up and rusty 1985 Buick Regal priced at $500 is a worse deal for nearly every prospective car buyer than is a new and shiny 2015 Toyota Camry priced 40 times higher at $20,000.
The above observations are, or ought to be, trite. Yet consider many of the typical discussions of “market power.” Suppose Acme Burger Joint, Inc., starts spending more effort to ensure that all of his burgers are of high quality and that its restaurants are cleaner and more pleasant than are those of competing burger joints. And suppose also – quite reasonably – that one result of Acme’s efforts is that it is now able to increase its profits by raising its burger prices higher than it could before. Does Acme Burger Joint have market power? The conventional economist answers ‘yes.’ Yet the correct answer is clearly no (at least as long as we do not wish to completely divest the word “power” of its conventional meaning and connotations).
Let’s continue with our hypothetical. Suppose that Acme’s new policy allows it to expand its market share at the expense of other burger joints. Acme eventually serves 75% of the restaurant-burger market. Popular discussions, legal documents, and even many academic economics books and articles would describe Acme as “controlling” 75% of the market, or even of “dominating” the market. But such language is wholly misleading.
In this hypothetical, Acme’s ability to profitably raise the price of its burgers, as well as its success at expanding its market share, are made possible only because consumers voluntarily accede to these outcomes. Acme purchases from consumers this ability and this success.
In other words, Acme’s price-raising ability and its success at increasing its market share are the direct results of mutually advantageous bargains that Acme makes, daily, with consumers (and with input suppliers). These bargains are mostly ‘unpriced.’ By ‘unpriced,’ I mean bargains that are for goods, services, or benefits that are not directly and explicitly priced. For example, by providing customers with unusually pleasant dining areas, Acme offers consumers something that consumers value. But Acme doesn’t directly charge for this amenity. Instead, Acme’s provision of this valuable amenity enables Acme to raise the price it charges for its burgers. What appears to be a rise in the price of Acme’s burgers is, in fact, a bundling of the prices of two different ‘goods’ into the list price of one of those goods. The higher price of Acme’s burger is, in part of course, the price of the burger itself, but this price includes also the price that Acme charges for its unusually pleasant dining areas.
Acme’s so-called “market power,” therefore, is no such thing. It is, instead, a benefit that consumers voluntarily ‘sell’ to Acme. The consumer, in effect, tells Acme the following: “If you, Acme, give to me unusually pleasant dining areas, then I, the consumer, will give to you in return my permission to raise the price that you charge me for your burgers.”
Of course, consumer would prefer that Acme supply the nice dining areas without raising the list price of its burgers (just as Acme would prefer that consumers be willing to pay higher list prices for its burgers without it having to go to the trouble and expense of supplying unusually pleasant dining areas in its restaurants). But that’s not how bargains work.
The point here is that what appears to the naïve observer to be Acme’s market “power” is, in fact, no such thing. Acme here has no power to force consumers to patronize its restaurants or to pay higher prices; instead, Acme purchases from consumers their permission for it to charge higher prices for its burgers.
The same analysis holds for input markets.
Suppose that Acme can trim some of its workers’ hourly wages without causing all of those workers to quit. In real-world competitive markets such ability is common. But in real-world competitive markets such ability is not the result of, or evidence of, anything that is reasonably called “market power.” This abiilty is, instead, the result of unpriced bargains – bargains that yield benefits to workers.
Perhaps Acme offers its workers valuable assurances against being too hastily laid-off; perhaps it offers its workers unusually congenial supervisors; perhaps it offers its workers especially attractive and safe workplaces. Such unpriced amenities are valuable to workers. One way that workers will respond to having such amenities is by being willing, if not as happy, to keep working for Acme even if Acme were to trim these workers’ hourly money wage.
The upshot is that observing that a firm has the ability to profitably raise the prices of its outputs is not necessarily an observation of that firm’s “power” in the output market. Likewise, observing that an employer has the ability to lower the monetary pay of its workers without having all of those workers quit is not necessarily an observation of that firm’s “power” in the labor market. Such observations are perhaps – and in a market economy are almost certainly – only evidence of complex and mutually advantageous bargains struck between firms, consumers, and workers.
