Evaluating Monopoly

Comparison with Perfect Competition

Market outcomes and efficiency1. Higher price and lower output compared

to the PC industry. Fig. 7.142. Impacts on surpluses (Fig. 7.15):

Consumer surplus smaller than in PC due to the higher price charged by the monopoly and the lower quantity produced.

Larger producer surplus, taking away a portion of CS.

Deadweight loss, i.e., the loss of total surplus due to a higher price and lower quantity.

3. Allocative inefficiency At the profit maximizing level of output: P>MC,

which means that some consumers place a greater value on the production of the good than what it costs the monopolist to produce it → allocative inefficiency and misallocation of resources.

4. Productive inefficiency At the profit maximizing level of output, the

average cost is larger thanm in ATC → productive inefficiency.

5. Lack of competition may give rise to higher costs.

Entry barriers make monopolist less concerned about keeping costs as low as possible.

X-inefficiency takes place when producing at a higher than necessary ATC. Different from productive inefficiency.

Lack of productive efficienty means that the firm does not produce at the minATC, but it does produce at some point on the ATC curve. X-inefficiency indicates that the costs are higher than ATC.

Costs > ATC

(X-inefficiency)

ATC > minimum ATC

(prod. inefficiency)

minimum ATC

(prod. efficiency)

Q

costs

ATC

Why a Monopoly may be desirable1. Economies of scale.

If the monopolist succeeds in achieving significant economies of scale, so that its costs fall, shifting the MC curve downwards, then its price and output levels may approach those of PC.

Consumers can gain from ES: lower costs → lower prices and larger quantity of output.

Society also benefits: lower costs → resources used more efficiently.

2. Product development and technological innovation. Some factors suggest that monopolies have good reasons to pursue innovation:

Economic profits allow financing large R&D projects.

Protection from competition allows the monopolist to enjoy the profits arising from their innovative activities (this is the rationale behind patent protection).

Firms may use product development and technological innovation as a means of creating barriers to entry for new potential rivals.

3. Possibility of greater efficiency and lower prices due to technological innovations.

If monopolies successfully engage in R&D that leads to technological innovations, they may adopt production processes and new technologies that can make them more efficient. Lower costs may be passed to consumers in the form of lower prices.

Monopoly power and government regulation Economists agree in that the disadvantages of

monopolies (absence of competition, higher prices, lower quantity of output, productive and allocative inefficiencies, higher than necessary costs, negative impacts on income distribution) outweigh its advantages.

Most countries do not encourage private monopolies. In the event of natural monopolies, these are owned or regulated by the governments, so that the interests of society are protected.

‘Monopoly power’ (the ability of a firm to set prices) applies not only to monopoly, but also to oligopoly. Oligopolistic firms sometimes act together (collude) in order to acquire greater monopoly power. If they succeed, they end up acting as a monopoly.

Legislation to reduce monopoly power applies also to firms that try to behave like monopolies.

Legislation to reduce monopoly power. Forms1. Legislation to protect competition Most countries have laws that try to

promote competition by preventing collusion between oligopolistic firms for the purpose of restricting competition between them, as well as preventing anti-competitive behaviour by a single firm that dominates a market.

The objective is to achieve a greater degree of allocative efficiency, by preventing monopolistic behaviour by a firm or group of firms. Example: Microsoft.

Firms that are found guilty are usually asked to pay fines or may be broken up into smaller firms.

Difficulties with competition policies:1. Interpretation of the legislation in

connection with the behaviour of the firms. a) determine which actions constitute competitive behaviour (different views are possible); b) laws might be vague.

2. Some gov may be stricter than others when enforcing laws, depending on their priorities or their political and ideological views.

3. Difficulty in finding evidence of the collusion and proving it, as collusion occurs secretly, as it is illegal.

2. Legislation in the case of mergers.A merger is an agreement between two

or more firms to join together and become a single firm. Reasons may be: capturing economies of scale, growing, acquiring monopoly power.

The single firm created from the merging may be very large and have too much monopoly power. Legislation involves limits on the size of the combined firms.

Difficulties: a. What firms should be allowed and what

firms should notb. Interpretation of the legislationc. Ideological differences among gov on the

desirability or not of a high degree of monopoly power.

Regulation of natural monopoly Not in the interest of society to

break up a natural monopoly into smaller firms, as this would result in higher average costs.

Gov usually regulate natural monopolies to ensure more socially desirable price and quantity outcomes.

1. Marginal cost pricing. That is, forcing the monopoly to charge

a price equal to marginal cost and thus achieving allocative efficiency.

It always leads to losses for the natural monopolist, making it impractical. As long as the D curve cuts the ATC curve to the left of the min ATC, it is not possible for the MC curve to cut the D curve at a point above ATC.

MR

D=AR

ATCMC

Qm Qac Qmc

P

Q

Pm

Pac

Pmc

1. Average cost pricing (P=ATC). The price is determined by the

intersection of the D curve with the ATC curve.

Also known as fair return pricing because the monopolist is forced to earn normal profit.

Productive efficiency is not achieved. Advantages:

1. monopolist earns normal profit and is not in danger of shutting down.

2. more efficient than the market solution.

Disadvantages:1. monopolist loses incentive to keeps its

costs down as he is guaranteed a price equal to its average costs.

2. The regulated monopoly may stop being a natural monopoly (if technological improvements change cost conditons) and still survive as a monopoly. Continued regulation provides protection to the firm from new (more efficient) competitors.

Monopoly compared with perfect competition

1. Price and output2. Efficiency3. R&D4. Economies of scale

1. Price and Output: higher price and smaller quantity than perfect competition.

2. Efficiency.a) Monopolies fail to achieve both productive

and allocative efficiency. Also: it may lead to X-inefficiency. Firms in PC achieve efficiency and are less likely to display X-inefficiency due to continuous pressure to lower their costs.

b) However, innovations in new technology may lower costs of production, leading to increased efficiencies.

3. R&D.a) Firms in PC unlikely to engage in R&D

due to lack of funds, lack of incentive to develop new products/differentiation and unable to create barriers to entry.

b) Monopolies have the needed resources to engage in R&D as well as the incentives. But high barriers to entry could make them less likely to innovate than smaller firms (in monopolistic competition) due to lack of competition.

4. Economies of scalea) No possibility for PC firms.b) Monopolies more likely to take

advantage of economies of scale and may use these to create a barrier to entry. However, they also offer the advantage of lower average costs and lower prices as well as greater quantities for consumers, and could approach those achieved in PC.