What Makes a Business Great: Meaningful & Durable Market Power
This article is part of a series about What Makes a Business Great?
Picture a farmer in Iowa. Six days a week, he gets up before dawn to put in twelve hours in the fields. It is hard work, but there is nothing else he’d rather do. Yet despite all his skill, effort and passion, the corn he grows is the same as any other farmer’s corn. He also has the same costs for seeds, fertilizer, labor and equipment as everyone else. If he went to his local grain elevator and asked for a price even just a little bit above what thousands of other farmers are asking, the operator would simply smirk and buy from the next guy in line. Corn is an agricultural commodity. Supply and demand conditions around the globe determine its price, and there is nothing any individual farmer can do to influence that price.
Now picture the CEO of an unregulated water utility. Although the product he sells may superficially seem to be a commodity, his company is the only one with the infrastructure necessary to supply water to the local market. It would be both uneconomic and infeasible for any other company to try to build a competing system. Global supply and demand conditions don’t determine the price of the water flowing through the pipes in those homes. The CEO of the water utility does. If he were to raise the price he charges by 20% or 30%, his customers might not even change their behavior.
These examples illustrate the extremes of market power. Market power is the ability of a firm to sustainably set the price of its products or services above the level that would prevail in a perfectly competitive market, one in which firms produce until marginal cost is equal to price. On one end of the spectrum is the corn farmer with no market power whatsoever. He is a price taker. He observes the market prices for corn and produces as much corn as it makes sense for him to produce given that price. On the other end of the spectrum is the unregulated water utility with immense market power. It is a price setter. The water utility aims for a price that maximizes its profits, one that is well above its marginal costs. Most businesses fall somewhere in between these two ends of the spectrum, typically closer to the price-taking corn farmer than the price-setting water utility.
Market power is an essential aspect of a great business. The defining characteristic of a great business is the ability to create a large amount of economic value – value in excess of a normal return – for its owners over the long-term. The only way a business can achieve that is by pricing what it sells at a level high enough to support superior returns on investment, or in other words, by exercising market power.
Every business faces a trade-off between price and volume. The more a business charges, the fewer units it will sell. The nature of this trade-off, known as the price elasticity of demand, determines market power. The more a business can mark-up what it sells without losing volume – in other words, the more inelastic its demand is – the more market power it has.
The price elasticity of demand for an overall market puts a limit on the market power of any individual firm in that market. Products and services with certain characteristics face less elastic demand than others. The fewer close substitutes there are for a product, the less elastic demand is likely to be. Demand for necessities is less elastic than that for discretionary items. Gasoline has both of those characteristics. Most cars can only run on gasoline, and most of the trips people take in their cars are necessary. As a result, demand for gasoline is inelastic. Additionally, how expensive something is and how frequently it is purchased will both affect its demand elasticity. Cheap, infrequent purchases will have less elastic demand than expensive, frequent ones. A company operating in a market with relatively inelastic demand generally has more potential for market power than the average company.
Competitive conditions in a market will influence the degree to which individual firms are able to realize any market power. Firms in a market with relatively inelastic demand can still struggle to mark-up their products above marginal cost if competition between firms is intense. The retail gasoline market again provides a good illustration. While demand for gasoline is inelastic overall, the demand for gasoline from any given gas station is highly elastic. A gas station that tries to unilaterally raise its price by a few pennies will eventually see its customers flock to lower-priced competitors. Conversely, collusion between firms in a market may be the most important factor behind the market power those firms realize.
One of the main factors that affects competitive conditions in a market – and thereby the market power that firms in the market enjoy – is the degree of market concentration. Businesses that face many competitors are less likely to have market power than those that face just a handful. The number of “major players” in a market is important too. If two firms control 80% of the market with twenty firms controlling balance, the leading two firms could still wield market power. Over the long-term, barriers to entry determine how concentrated a market will be. Barriers to entry may include supply-side economies of scale, demand-side economies of scale (a.k.a. “network effects”), exclusivity granted by laws or regulations, resource control, absolute cost advantages and switching costs, among others.
Individual firms generate market power in two general ways. The first is through differentiation. The more differentiated a product is relative to its competitors, the more price inelastic the demand for that product could be. Differentiation could exist in terms of brand, technology, quality, location and customer service, among other features. The second is through cost advantages. A business with lower costs than those of competitors could sell an undifferentiated product into a competitive market and still earn a large mark-up over its marginal costs. A business could have cost advantages due to superior scale, proprietary technology, or control of critical resources, among other reasons.
Most businesses have some measure of market power. Great businesses have market power that is both meaningful and durable. A business has meaningful market power if its market power is sufficient to support superior returns on investment. At Hinde Group, we generally define that as return on equity of at least 15% and ideally more than 20%. Market power is durable if it is likely to persist over the long-term. The durability of a business’s market power depends on its source. For example, market power derived from strong network effects is far more durable than that derived from being first to market with an innovative product design. Facebook’s market power is far more durable than UNTUCKit’s, in other words. At Hinde Group, we think durable market power comes from sources that are unlikely to erode over the next five to ten years.
Conclusion
Great businesses are those that create large amounts of value for their owners over time. One of the essential elements to achieving that is meaningful and durable market power. A business has market power if it can sustainably charge a big mark-up over its costs due to facing price inelastic demand. The realization of market power in any given market is affected by the characteristics of the products that define the market as well as the competitive conditions in the market. Within a market, individual firms generate market power through favorable differentiation, cost advantages or some combination of those two. A business’s market power is meaningful if it supports normalized return on equity of at least 15%. A business’s market power is durable if it is likely to persist for at least five to ten years. The sources of a firm’s market power determine both its meaningfulness and its durability.
If you found this interesting, please register below to join our distribution list. We aim to share only high quality, thought-provoking content, including extensive discussions of our investments. If you are interested in investing with Hinde Group, please let us know through our contact form.