Limiting the use of market power can help fight inflation

Raising interest rates often seems to be our only weapon against rising inflation. But understanding the role of market power and limiting its use can also play a role, as can taking sectoral measures.

Economists often assess inflation assuming that markets are competitive and that all sectors of the economy behave the same. These assumptions can lead to damaging policy choices, particularly regarding interest rate hikes in response to inflation.

Australian markets are generally far from highly competitive and, on the contrary, are often characterized by considerable concentration and market power. Moreover, current inflation owes much to shocks in key sectors, such as gas and electricity. Both of these points raise questions about how best to respond to rising inflation in Australia.

Many sectors of our economy are dominated by just a few companies; think beer, groceries, energy and telecommunications retail, resources, elements of the digital economy, banking and many more. This means that dominant firms have some market power; that is, they can set prices at higher levels knowing that competitors are unlikely to undercut them and take market share from them.

When inflation is high, dominant companies often realize that they can raise prices beyond any cost increases, because consumers will accept it better. They will often do this subtly over time.

We need to understand the sectors that can contribute the most to inflation and consider sectoral responses rather than rate hikes.

In concentrated markets, companies can also easily see the impacts on their few competitors and they can observe and track the behavior of others. They are convinced that no one will fall behind on the price increases because there are advantages for all. Contrast this with competitive markets where excessive pricing can be punished by loss of market share to any number of competitors able to seize an opportunity.

In addition, firms gain market and therefore price-setting power by creating barriers to entry for new firms and by controlling supply versus demand. This means they can raise prices knowing that market responses will be limited.

Firms with market and pricing power are also less likely to restrain prices in response to interest rate increases. Indeed, it is not competition but the dominant behavior of the firm that determines pricing decisions.