Monopoly and Efficiency

The fact that price in monopoly exceeds marginal cost suggests that the monopoly solution violates the basic condition for economic efficiency, that the price system must confront decision makers with all of the costs and all of the benefits of their choices. Efficiency requires that consumers confront prices that equal marginal costs. Because a monopoly firm charges a price greater than marginal cost, consumers will consume less of the monopoly’s good or service than is economically efficient.

To contrast the efficiency of the perfectly competitive outcome with the inefficiency of the monopoly outcome, imagine a perfectly competitive industry whose solution is depicted in Figure 10.11 "Perfect Competition, Monopoly, and Efficiency". The short-run industry supply curve is the summation of individual marginal cost curves; it may be regarded as the marginal cost curve for the industry. A perfectly competitive industry achieves equilibrium at point C, at price P_c and quantity Q_c.

Figure 10.11 Perfect Competition, Monopoly, and Efficiency

Given market demand and marginal revenue, we can compare the behavior of a monopoly to that of a perfectly competitive industry. The marginal cost curve may be thought of as the supply curve of a perfectly competitive industry. The perfectly competitive industry produces quantity Q_c and sells the output at price P_c. The monopolist restricts output to Q_m and raises the price to P_m.

Reorganizing a perfectly competitive industry as a monopoly results in a deadweight loss to society given by the shaded area GRC. It also transfers a portion of the consumer surplus earned in the competitive case to the monopoly firm.

Now, suppose that all the firms in the industry merge and a government restriction prohibits entry by any new firms. Our perfectly competitive industry is now a monopoly. Assume the monopoly continues to have the same marginal cost and demand curves that the competitive industry did. The monopoly firm faces the same market demand curve, from which it derives its marginal revenue curve. It maximizes profit at output Q_m and charges price P_m. Output is lower and price higher than in the competitive solution.

Society would gain by moving from the monopoly solution at Q_m to the competitive solution at Q_c. The benefit to consumers would be given by the area under the demand curve between Q_m and Q_c; it is the area Q_mRCQ_c. An increase in output, of course, has a cost. Because the marginal cost curve measures the cost of each additional unit, we can think of the area under the marginal cost curve over some range of output as measuring the total cost of that output. Thus, the total cost of increasing output from Q_m to Q_c is the area under the marginal cost curve over that range—the area Q_mGCQ_c. Subtracting this cost from the benefit gives us the net gain of moving from the monopoly to the competitive solution; it is the shaded area GRC. That is the potential gain from moving to the efficient solution. The area GRC is a deadweight loss.

Monopoly and Equity

The monopoly solution raises issues not just of efficiency but also of equity. Figure 10.11 "Perfect Competition, Monopoly, and Efficiency" shows that the monopolist charges price P_m rather than the competitive price P_c; the higher price charged by the monopoly firm reduces consumer surplus. Consumer surplus is the difference between what consumers are willing to pay for a good and what they actually pay. It is measured by the area under the demand curve and above the price of the good over the range of output produced.

If the industry were competitive, consumer surplus would be the area below the demand curve and above P_cC. With monopoly, consumer surplus would be the area below the demand curve and above P_mR. Part of the reduction in consumer surplus is the area under the demand curve between Q_c and Q_m; it is contained in the deadweight loss area GRC. But consumers also lose the area of the rectangle bounded by the competitive and monopoly prices and by the monopoly output; this lost consumer surplus is transferred to the monopolist.

The fact that society suffers a deadweight loss due to monopoly is an efficiency problem. But the transfer of a portion of consumer surplus to the monopolist is an equity issue. Is such a transfer legitimate? After all, the monopoly firm enjoys a privileged position, protected by barriers to entry from competition. Should it be allowed to extract these gains from consumers? We will see that public policy suggests that the answer is no. Regulatory efforts imposed in monopoly cases often seek to reduce the degree to which monopoly firms extract consumer surplus from consumers by reducing the prices these firms charge.

Monopoly and the Concentration of Power

The objections to monopoly run much deeper than worries over economic efficiency and high prices. Because it enjoys barriers that block potential rivals, a monopoly firm wields considerable market power. For many people, that concentration of power is objectionable. A decentralized, competitive market constantly tests the ability of firms to satisfy consumers, pushes them to find new products and new and better production methods, and whittles away economic profits. Firms that operate in the shelter of monopoly may be largely immune to such pressures. Consumers are likely to be left with fewer choices, higher costs, and lower quality.

Perhaps more important in the view of many economists is the fact that the existence of economic profits provides both an incentive and the means for monopolists to aggressively protect their position and extend it if possible. These economists point out that monopolists may be willing to spend their economic profits in attempts to influence political leaders and public authorities (including regulatory authorities) who can help them maintain or enhance their monopoly position. Graft and corruption may be the result, claim these critics. Indeed, Microsoft has been accused by its rivals of bullying computer manufacturers into installing its web browser, Internet Explorer, exclusively on their computers.

Attitudes about Microsoft reflect these concerns. Even among people who feel that its products are good and fairly priced, there is uneasiness about our seeming dependence on them. And once it has secured its dominant position, will it charge more for its products? Will it continue to innovate?

Public Policy Toward Monopoly

Pulling together what we have learned in this chapter on monopoly and previously on perfect competition, Table 10.1 "Characteristics of Perfect Competition and Monopoly" summarizes the differences between the models of perfect competition and monopoly. Most importantly we note that whereas the perfectly competitive firm is a price taker, the monopoly firm is a price setter. Because of this difference, we can object to monopoly on grounds of economic efficiency; monopolies produce too little and charge too much. Also, the high price and persistent profits strike many as inequitable. Others may simply see monopoly as an unacceptable concentration of power.

Public policy toward monopoly generally recognizes two important dimensions of the monopoly problem. On the one hand, the combining of competing firms into a monopoly creates an inefficient and, to many, inequitable solution. On the other hand, some industries are characterized as natural monopolies; production by a single firm allows economies of scale that result in lower costs.

The combining of competing firms into a monopoly firm or unfairly driving competitors out of business is generally forbidden in the United States. Regulatory efforts to prevent monopoly fall under the purview of the nation’s antitrust laws, discussed in more detail in a later chapter.

At the same time, we must be careful to avoid the mistake of simply assuming that competition is the alternative to monopoly, that every monopoly can and should be replaced by a competitive market. One key source of monopoly power, after all, is economies of scale. In the case of natural monopoly, the alternative to a single firm is many small, high-cost producers. We may not like having only one local provider of water, but we might like even less having dozens of providers whose costs—and prices—are higher. Where monopolies exist because economies of scale prevail over the entire range of market demand, they may serve a useful economic role. We might want to regulate their production and pricing choices, but we may not want to give up their cost advantages.

Where a natural monopoly exists, the price charged by the firm and other aspects of its behavior may be subject to regulation. Water or natural gas, for example, are often distributed by a public utility—a monopoly firm—at prices regulated by a state or local government agency. Typically, such agencies seek to force the firm to charge lower prices, and to make less profit, than it would otherwise seek.

Although economists are hesitant to levy blanket condemnations of monopoly, they are generally sharply critical of monopoly power where no rationale for it exists. When firms have substantial monopoly power only as the result of government policies that block entry, there may be little defense for their monopoly positions.

Public policy toward monopoly aims generally to strike the balance implied by economic analysis. Where rationales exist, as in the case of natural monopoly, monopolies are permitted—and their prices are regulated. In other cases, monopoly is prohibited outright. Societies are likely to at least consider taking action of some kind against monopolies unless they appear to offer cost or other technological advantages.