How does market power contribute to market failure?

Market power contributes to market failure by enabling firms to manipulate prices and limit competition, leading to inefficiency.

Market power refers to the ability of a firm to influence the price of a product or service in the market. This power is often held by firms in monopolistic or oligopolistic markets, where there are few competitors. When a firm has significant market power, it can set prices above the competitive level, leading to allocative inefficiency. This is a form of market failure, as resources are not being allocated in the most efficient way.

In a perfectly competitive market, prices are determined by supply and demand. However, when a firm has market power, it can set prices higher than the marginal cost of production, leading to a deadweight loss. This is the loss of economic efficiency that occurs when the equilibrium outcome is not achievable or not achieved. In this case, the firm's profit-maximising price is above the socially optimal level, leading to under-consumption of the good or service.

Moreover, firms with market power can engage in anti-competitive practices, such as predatory pricing or exclusive contracts, to limit competition. This can lead to a lack of innovation and choice in the market, further contributing to market failure. For example, a monopolist might lower prices to drive competitors out of the market, and then raise prices once it has established a monopoly position. This behaviour prevents new firms from entering the market, stifering competition and innovation.

Market power can also lead to income inequality, another form of market failure. When firms can set prices above the competitive level, they can earn supernormal profits, leading to a concentration of wealth. This can exacerbate income inequality, as the owners of the firm earn higher profits at the expense of consumers, who have to pay higher prices.

In conclusion, market power can contribute to market failure in several ways. It allows firms to set prices above the competitive level, leading to allocative inefficiency and deadweight loss. It can also limit competition and innovation, and contribute to income inequality.