A local water utility charges $4 per thousand gallons. Its marginal cost of delivery is $1. Its markup is 300 percent. If you need water, you pay — there is no competitor to switch to. This is market power in its most visible form: the ability to set price substantially above marginal cost because buyers have no real alternative. Understanding where market power comes from, how it's measured, and how policy addresses it is central to market structure economics.
In plain terms
Market power is the ability of a firm to profitably set price above marginal cost. In a perfectly competitive market, no firm has market power — any attempt to price above MC results in zero sales as buyers switch to identical alternatives. Market power exists wherever the firm faces a downward-sloping demand curve — meaning it loses sales gradually, not all at once, when it raises price.
The degree of market power is measured by the Lerner Index:
L = (P – MC) / P
- L = 0: no market power; the firm is a price-taker (P = MC)
- L = 1: maximum market power; marginal cost is zero (pure digital goods approximate this)
- 0 < L < 1: intermediate market power; the larger L, the greater the pricing power
The Lerner Index equals the inverse of the price elasticity of demand faced by the firm: L = 1 / |ε|. Firms facing inelastic demand have more market power; firms facing elastic demand (more substitutes) have less.
Why it works this way
Market power stems from reduced competition — fewer substitutes, higher switching costs, stronger barriers to entry. A firm with a strong brand, a patent, or a network advantage can raise prices without losing all customers because some buyers value the specific product enough to pay the premium. The less elastic the demand the firm faces (holding cost constant), the more market power it has.
The DOJ Antitrust Division market definition framework uses the SSNIP test (Small but Significant Non-transitory Increase in Price) to identify whether a firm has market power: if a hypothetical monopolist could profitably raise price by 5–10 percent above competitive levels, the firm has market power in a defined market.
A real example
The FTC's studies of pharmaceutical market power document drug pricing before and after generic entry. Before patent expiry, the branded manufacturer faces limited substitutes and exercises substantial market power — prices can be 10–100× marginal production cost. After generic entry, market power collapses as competition introduces substitutes. The Lerner Index would show L approaching 1 for a patented drug and near 0 for a genericized one.
Why it matters
Market power is the central concept in antitrust economics. Mergers, predatory pricing, exclusive dealing, and platform dominance are all analyzed through the lens of whether they create, extend, or abuse market power — and whether that market power generates consumer harm. A firm with market power transfers surplus from consumers to producers and creates deadweight loss by pricing above MC, which is why regulators care deeply about its measurement and sources.
