Question:
I have a question about the economic term “pricing power.” The term pricing power is often used to describe companies that successfully command big premiums for their products, like Apple. Can companies that compete solely on price have pricing power? For example, Wal-Mart charges lower prices than its competition because of its superior cost structure. Does Wal-Mart have pricing power?Answer:
A seller has market power if it is able to PROFITABLY price higher than the competitive price because it has a downward sloping demand curve and sets its output where marginal revenue equals marginal cost but sets its price above its marginal cost. In a purely competitive market, firms cannot do this because a firm in such a market is a price taker: it faces a horizontal (flat) demand curve where price must equal marginal cost. Ugh, econ speak.
In (mostly) non-econ speak…if two farmers with identical costs are selling indistinguishable onions next to each other at a farmer’s market, you’d expect the onions to be the same price. In that market, the firms produce stuff and “the market” sets the price because the sellers compete their prices down to what we call marginal cost--the least an onion farmer can take and stay in business. Both farmers sell onions where price equals marginal cost because they cannot influence the demand for identical onions. If one farmer sets a price higher than the other, customers go to the competitor. If a farmer sets a price below marginal cost it loses money on every sale and goes out of business.
Now, suppose something differentiates the shopping experience: the onions are identical but one farmer is a grump and the other is very approachable. The likable farmer can raise prices a little and get a premium. By raising prices, it loses SOME customers who are just looking for the cheapest onion, but not all of them. The customers it keeps are willing to pay the higher price in order to interact with a friendly farmer. In Apple’s case, perhaps it differentiates its iPhone through apps, features and service, etc. But, Apple only has what economists would call market power if the price is above marginal cost. If those apps, features and service really do cost more, then Apple might be simply setting its higher price based on its higher marginal cost but doesn’t go out of business because its customers really want those things. You cannot look at a price and immediately tell whether it’s a demand (preference) thing or a supply (cost) thing. You cannot claim a seller has market power unless you know whether price is above marginal cost.
The WalMart case is similar but unlike Apple. WalMart mostly buys other firms’ stuff and re-sells it. Why can it re-sell that stuff cheaper than another retailer? Why doesn’t WalMart go out of business offering a lower price than its competitors? If it were due to market power, here is how it could come about. The firm PROFITABLY buys a product below its marginal cost (specifically what we call its marginal acquisition cost, the cost of getting stuff from a manufacturer, putting it on the shelf, etc.) and re-sells it at a lower price than its competitors (though not at a lower price than what it bought it for). The onion farmers cannot undercut each other past some go-out-of-business price point. However, a firm could price below its marginal (acquisition) cost without going out of business if it is a really big firm that influences supply when it buys stuff. Suppose a third onion seller comes to town, Super Onion. Super Onion buys a lot of onions and sets up a shop across from the farmers market. Super Onion is so big that it is able to influence the supply of onions when it makes its purchases. Super Onion influences supply so much, in fact, that it squeezes its suppliers' margins and offers low prices to customers, possibly at a lower price than the other two onion farmers. (Why would that be? Perhaps scale economies where costs go down as you get larger…that’s another issue.) The point is this would be a case of market power and is a concern because suppliers are getting squeezed.
What if you don’t have that kind of power over your suppliers? Let’s get rid of the Super Onion store and go back to that two-onion seller case with no market power over supplies; but now one sells at a lower price without going out of business because it has lower costs. Maybe the low-price seller figured out ways that its competitor has not figured out for lowering marginal cost--it has a more fuel-efficient truck, for example. If the higher priced vendor doesn’t figure out how to lower its costs, it will go out of business. This was not a case of pricing behavior due to market power for either firm, it was just cost.
Is WalMart influencing supply and squeezing its suppliers (market power) or has WalMart just figured out how to do things at a lower cost? Either way, we could say the firm has pricing power but only in the former case are economists typically concerned. Discerning whether firms are pricing because they have market power or simply because they have figured out ways to lower costs is tougher than it sounds. If you’re interested, I wrote a longer “Ask an Economist” answer about dominant firms that is somewhat related.
