3 - Industry Models of Market Power

Summary

Is a firm in an industry exercising market power? If we observe price and marginal cost, we can directly determine whether the firm sets its price above its marginal cost. Unfortunately, we usually observe only price and factors that are associated with demand and with cost; we do not have explicit information on total or marginal cost. One approach to overcoming the problem of not knowing marginal cost is to estimate the firm's behavior – or the average behavior of all firms within an industry – and marginal cost simultaneously, using a structural model. Alternatively, a researcher can use a reduced-form or nonparametric approach to determine whether firms have market power by seeing how price varies with shifts in cost (or factors that shift cost).

The structural approach has two key advantages. The model provides a direct estimate of market power. Moreover, one can use the estimated model to simulate the effects of changes in the market (as long as they do not affect the underlying market structure), which can be used for public policy debates. For example, structural models have been used to simulate the effects of mergers on price (and hence welfare): Werden and Froeb (1994), Slade (1998), Nevo (2000), and Hausman and Leonard (2005). The main disadvantage of the structural approach is that the results depend critically on a variety of assumptions concerning functional form, distributions, and other facts that are not generally known to the econometrician.