Endogenous Market Power

In this paper, I propose a framework for studying market interactions in economies without assuming that traders are price-takers or Nash players. The model endogenously derives market power from primitives: endowments, preferences, and cost functions. The novelty of the approach lies in the treatment of the off-equilibrium behavior of the economy. A trader correctly anticipates that any deviation from equilibrium quantity will be followed by a price change sufficient to encourage all other traders to absorb the deviation. This price response defines a downward sloping demand curve facing each trader, and traders take into account the ability to affect prices in equilibrum, but also when absorbing unilateral deviations. I show that equilibrium defined in this way exists in economies with smooth utility and cost functions, is generically locally unique and generically Pareto inefficient. The framework suggests that trader's market power depends positively on the convexity of preferences and cost functions of the trading partners. Consequently industries with nearly constant marginal costs are fairly competitive, even if the number of firms is small. In addition market power of different traders reinforce each other. The model predicts the following effects of non-competitive trading: the volume of trade is reduced and price bias can be positive or negative depending of the third derivatives. Unlike the Marshallian approach, the framework makes it possible to determine market structure in a coherent way even if the number of operating firms is small. It also defines equilibrium prices and quantities when there are increasing returns to scale or a bilateral monopoly.

For more information, contact David Cass.