How One Large Seller Can Drive The Market Price Up To A Monopoly Price
The key factor is if the large seller’s market-share is materially greater than the industry’s excess production capacity
By David Grace (Amazon Page — David Grace Website)
People intuitively think that the price for a product cannot increase so long as
- There are multiple competing sellers
- The cost of producing the product has not increased, and
- There is a sufficient supply at the current price to fully satisfy current demand.
Those people are wrong.
How Are Sellers Getting Away With Massive Price Increases?
Large sellers have figured out that they don’t need an illegal cartel in order to drive the market price up to the monopoly price.
For vital products like housing, medicine, energy, food and the like, if the market share of one producer is substantially larger than the market’s capacity to supply additional units at the current price, then that one large seller can cause the product’s market price to increase to the monopoly price without participating in an illegal cartel.
Sample Numbers That Show How This Can Be Done
Assume the following facts:
- A city has 10,000 residential rental units with a 10% vacancy factor — 9,000 rented, 1,000 empty.
- The largest landlord, Acme, has 3,000 rental units, 2,700 rented, 300 empty.
- Acme’s Market Share is 2,700/9,000 = 30%
- Other smaller landlords have 7,000 rental units, 6,300 rented, 700 empty.
- The Excess Capacity (vacant units) not controlled by Acme is 700 units
- The market rate rent is $1,000/month.
The Available Product Percentage is the ratio of available product not owned by Acme (700 vacant units owned by other landlords) to the total amount of all rented units (9,000 occupied units).
- The Available Product %age is 700/9,000 | Result = 7.778%
- Capacity To Market Share is the Available Product %age/Acme’s Market Share — 7.778%/30% = 25.93%
The higher the Capacity To Market Share the lower the amount that Acme can profitably raise its rent.
- As the available product not owned by Acme (700 units) goes up, the Capacity To Market Share ratio goes up and the less Acme can raise its rent.
- As Acme’s market share (30%) goes down, the Capacity To Market Share ratio goes up and the less Acme can raise its rent.
The lower the Capacity To Market Share the higher Acme can profitably raise its rent.
- As the available product not owned by Acme (700 units) goes down, the Capacity To Market Share ratio goes down and the more Acme can raise its rent.
- As Acme’s market share (30%) goes up, the Capacity To Market Share ratio goes down and the more Acme can raise its rent.
What Acme Knows About The Market
Acme knows that there are 700 vacant rental units elsewhere in the city and that if it raises its rent by 50% to $1,500/month then its poorest tenants will immediately move out and take those 700 vacant units, reducing its occupancy from 2,700 units to 2,000 units.
Once that happens there will be no cheaper units available anywhere in the city — the market’s ability to provide housing units not controlled by Acme will be zero.
That means that Acme will essentially become a monopoly provider to its remaining 2,000 tenants who will either have to find a way to pay the higher rent or
- Leave the city,
- Move in with their parents, or
- Become homeless.
The number of tenants who do one of those three things is the Additional Sales Decline.
If a small enough number of these 2,000 tenants are willing or able to move out, if the Additional Sales Decline is small, then Acme will be able make more money by increasing rents to the maximum-revenue price, the monopoly price.
The Formula That Determines If Acme Can Increase Its Revenue By Increasing Its Rent
Acme asks itself, “How many additional rental units can I lose beyond those 700 units and still make more money if I raise my rent to $1,500/month?”
The formula is:
If
(Acme’s Current Sales)
MINUS
(Non-Acme Excess Supply + Additional Sales Decline)
DIVIDED BY
Acme’s Current Unit Sales
(Ratio #1)
IS GREATER THAN
The Old Price/New Price
(Ratio #2)
then raising the rent will increase Acme’s revenue.
— — New Revenue = (Ratio #1/Ratio #2) TIMES Old Revenue
New Revenue At Various Occupancy Levels
Let’s plug in some numbers.
If (2,700 current Acme rentals)
MINUS
(700 + Additional Sales Decline)
DIVIDED BY
2700
IS GREATER THAN
$1,000/$1,500 | Result = 66.67%
then raising the rent will be profitable.
Loss Of An Additional 100 Rentals
If the Additional Sales Decline is only 100 additional rental units that will be lost after the price increase then
2700 MINUS (700 +100)/2700 = 70.4% which is > 66.67% so the price increase will generate additional revenue.
2,700 rented units X $1,000/month rent = $2,700,000 monthly revenue
1,900 rented units X $1,500/month rent = $2,850,000 monthly revenue | Result = $150K revenue increase
New Revenue = 70.4%/66.67% X $2,700,000 = $2,850,000 (rounded)
Moreover, having 800 fewer occupied apartments will further increase Acme’s profits by reducing Acme’s utility, maintenance, repair, and other costs.
Loss Of An Additional 200 Rentals
If the Additional Sales Decline is 200 additional units lost after the price rise then 1800/2700 = 66.67% which = 66.67% so the price increase will neither increase nor decrease gross revenue.
1,800 rented units X $1,500/month rent = $2,700,000 monthly revenue | No change
Loss Of An Additional 300 Rentals
If the Additional Sales Decline is 300 additional rental units lost after the price rise then 1700/2700 = 63% which is < 66.67% so the price increase will cause a reduction in Acme’s revenue.
1,700 rented units X $1,500/month rent = $2,550,000 monthly revenue | Result = $150K revenue loss
New Revenue = 63%/66.67% X $2,700,000 = $2,550,000 (rounded)
Determining When Revenue Will Increase
You can simplify the formula for determining if revenue will increase as follows:
- If Old price/New price < New Sales Volume/Old Sales Volume | Then Revenue will increase
- If Old price/New price = New Sales Volume/Old Sales Volume | Then Revenue will not change
- If Old price/New price > New Sales Volume/Old Sales Volume | Then Revenue will decrease
New Sales Volume Formula
New Sales Volume =
1 MINUS
(Capacity To Market Share ratio)
TIMES
(Current Sales)
MINUS
Additional Sales Decline
New Sales = (1 MINUS .2593) X (2,700) MINUS 100 | Result = 1,900 units New Sales
$1,000/$1,500 (.667) < 1,900 units/2,700 units (.704) | Revenue will increase
What Decreases The Volume of New Sales
- As the Capacity To Market Share ratio goes up, the number of new sales goes down.
- As the Additional Sales Decline goes up the number of new sales goes down.
Effect Of Decrease In New Sales
- As the number of New Sales goes down, revenue goes down.
Acme’s Price Increase Causes Other Landlords To Also Increase Their Rents
The other landlords know that:
- The only vacant units remaining in the city are the 1,100 units in Acme’s buildings
- Acme is pricing all its 1,100 vacant units at $1,500/month
- Acme is not going to price compete with itself
- Because there are no vacant units priced less than $1,500/month the other landlords are now monopoly providers to their own tenants who will have little alternative but to also pay $1,500/month rent
While a few of the other landlords may feel sorry for their tenants, most will recognize that there is no competitive barrier to their also raising their rents to match Acme’s $1,500/month because they know that their tenants’ only options are to either pay the new $1,500 rent or move in with family or friends, leave town, or become homeless.
If those tenants who move out or are evicted represent 10% of the other landlords’ current tenants then the other landlords will see their occupancy fall from 7,000 units at $1,000/month ($7,000,000/month) to 6,300 units at $1,500/month ($9,540,000/month).
Rents Have Increased Even Though There Are More Vacant Apartments
So, while the number of vacant units in the city has now increased to 1,100 Acme units + 700 other units = 1,800/10,000, an 18% vacancy rate, the price of rental units has gone up by 50%.
There is no economic motive for the landlords to reduce rents in order to fill these vacant units because any reduction in rent would primarily come from cannibalizing their existing customer base and would thus reduce their gross revenue while increasing their costs.
The elimination of the availability of any additional units at a lower price has allowed the other landlords to price their products at the same level they would if they were members of a cartel.
Remember that the landlords can’t offer a vacant apartment to a new tenant for $1,250/month rent when their current tenants are being charged $1,500/month for an identical unit.
A price war would cost everyone money.
So, not only is there no downward price pressure on Acme from the city’s other lessors to reduce its price, but Acme’s 50% price increase will cause the other lessors to raise their prices to match Acme’s higher price.
Also, since there is an 18% vacancy factor, there is little to no incentive for developers to build more rental units.
The Ratio Of The Available Capacity To Market Share
If the ratio of the Available Market Capacity to a large seller’s market share — the Capacity To Market Share ratio — for a vital product is relatively low, then the profit motive will force the other sellers to increase their prices to match the new higher price charged by the large-market-share seller.
If the ratio of the Available Market Capacity to a large seller’s market share — the Capacity To Market Share ratio — for a vital product is relatively high, then price competition by the other sellers will force the large-market-share seller to reduce its new higher price to match the lower prices charged by those other sellers.
What Old Economic Theories Missed
Where did the simplistic notions about price-competition balancing supply against demand go wrong?
When dealing with vital products like medicine, energy, housing, staple foods and the like, those comic-book rules of supply, demand, and price fail to consider the relationship between
- Low excess product capacity,
- One or more companies’ high market share,
- High capital cost to increase market capacity and
- Long lead time to increase market capacity
It should be noted that between the first quarter of 2020 and the second quarter of 2021 pre-tax U.S. Corporate profits have increased by almost 75%.
The Amount Of The “Additional Sales Decline” Is The Limiting Factor
When the total of the Additional Sales Decline plus the market’s Excess Capacity is sufficient to reduce the ratio of New Sales to Old Sales below the ratio of the Old Price to the New Price, the contemplated price increase will not produce additional revenue.
The key question that will determine how high prices can go is:
“What will the Additional Sales Decline for a particular product be at various price points?”
I discuss that in this column:
— David Grace (Amazon Page — David Grace Website)
