Market power Market Power Models: A Review

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Chapter 3 Market Power Models: A Review

The previous chapter illustrates that the Indonesian palm oil industry has an oligopolistic duopolistic market structure. Unlike competitive and monopolistic markets, there is no single general model for an oligopolistic duopolistic market. Each oligopoly duopoly model focuses on certain aspects of the case being analysed to answer a particular set of the research questions. Therefore, in order to identify the most suitable model to the Indonesian palm oil industry, different models need to be explored. In comparing these models, this chapter will focus on one main feature that needs to be captured in each one of them, which is the ability of the oligopolists duopolists to respond to their rivals’ actions Gollop and Roberts 1979. Specifically, this chapter is organised as follows. Section 3.1 illustrates the idea of market power and its well-known measure, the Lerner index. Sections 3.2 and 3.3 explore models that have been developed to measure market power, using the structure–conduct– performance SCP and the new empirical industrial organization NEIO approaches, respectively. The first approach is explored in Section 3.2, including related critiques. The second approach, covering static and dynamic models, is then discussed in section 3.3. The static models are grouped into the comparative static and conjectural variations models; the discussion is focused more on the conjectural variations models, as they appear to have been broadly used in previous studies. The dynamic models cover the repeated-game and state-space game models. Each has different assumptions, determining the appropriateness of its application to certain cases. Finally, in section 3.4, some concluding comments are presented.

3.1 Market power

One of the main features of a competitive market is that firms behave as price takers and sell their output at prices equal to marginal costs. In an imperfectly competitive market, Universitas Sumatera Utara 33 firms have the ability to influence price and sell their output at prices above marginal costs. This idea was formalised by Lerner 1934, p. 161 with an index known as the Lerner index p c L p − ≡ , where p is the output price and c is the marginal production cost. A higher Lerner index is interpreted as a higher degree of market power: This interpretation needs to be used with caution, because the price–cost margins that determine the index can increase either with an increase in price or a decrease in marginal cost. The interpretation will be appropriate if the increase in the Lerner index is triggered by an increase in output prices. If the increase stems from a decrease in marginal costs, a higher Lerner index may reflect higher efficiency rather than market power. This ambiguity may arise if the observations are derived from single-period equilibria. The one-shot game framework of such equilibria precludes both the possibility of new entrants to the markets and firms’ consideration of their rivals’ responses. In a multi- period case, positive price–cost margins will attract new entrants to the markets, or give incentives for rivals to increase their output quantity. If there are no barriers to entry—as in competitive markets—this process may continue until prices equal marginal costs again in equilibrium. Therefore, the existence of a positive price–cost margin can only be considered as evidence of market power if its occurrence is persistent over time. Although the Lerner index has been broadly accepted as a good measure of market power, most studies do not directly use it because marginal costs are usually difficult to determine. As an alternative, many models have been developed in order to measure market power. These models can be divided into the structure–conduct–performance SCP and the new empirical industrial organization NEIO approaches Tirole 1988.

3.2 Structure–conduct–performance approach