The Economic Inefficiency of Monopoly

Market Structures and Economic Welfare

Within economists' focus on welfare analysis, or the measurement of value that markets create for society is the question of how different market structures- perfect competition, monopoly, oligopoly, monopolistic competition, and so on- affect the amount of value created for consumers and producers.

Let's examine the impact of a monopoly on the economic welfare of consumers and producers.

Market Outcome for Monopoly versus Competition

In order to compare the value created by a monopoly to the value created by an equivalent competitive market, we need to first understand what the market outcome is in each case.

A monopolist's profit-maximizing quantity is the quantity where marginal revenue (MR) at that quantity is equal to marginal cost (MC) of that quantity. Therefore, a monopolist will decide to produce and sell this quantity, labeled Q_M in the diagram above. The monopolist will then charge the highest price it can such that consumers will buy all of the firm's output. This price is given by the demand curve (D) at the quantity that the monopolist produces and is labeled P_M.

Market Outcome for Monopoly versus Competition

What would the market outcome for an equivalent competitive market look like? To answer this, we need to understand what constitutes an equivalent competitive market.

In a competitive market, the supply curve for an individual firm is a truncated version of the firm's marginal cost curve. (This is simply a result of the fact that the firm produces up until the point where price is equal to marginal cost.) The market supply curve, in turn, is found by adding up the individual firms' supply curves- i.e. adding up the quantities that each firm produces at each price. Therefore, the market supply curve represents the marginal cost of production in the market. In a monopoly, however, the monopolist *is* the entire market, so the monopolist's marginal cost curve and the equivalent market supply curve in the diagram above are one and the same.

In a competitive market, the equilibrium quantity is where the market supply curve and the market demand curve intersect, which is labeled Q_C in the diagram above. The corresponding price for this market equilibrium is labeled P_C.

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Monopolies and Monopoly Power

By Mike Moffatt

Monopoly versus Competition for Consumers

We've shown that monopolies lead to higher prices and smaller quantities consumed, so it's probably not shocking that monopolies create less value for consumers than competitive markets. The difference in the values created can be shown by looking at consumer surplus (CS), as shown in the diagram above. Because both higher prices and lower quantities reduce consumer surplus, it's pretty clear that consumer surplus is higher in a competitive market than it is in a monopoly, all else being equal.

Monopoly versus Competition for Producers

How do producers fare under monopoly versus competition? One way of measuring the well-being of producers is profit, of course, but economists usually measure the value created for producers by looking at producer surplus (PS) instead. (This distinction doesn't change any conclusions, however, since producer surplus increases when profit increases and vice versa.)

Unfortunately, the comparison of value isn't as obvious for producers as it was for consumers. On one hand, producers are selling less in a monopoly than they would in an equivalent competitive market, which lowers producer surplus. On the other hand, producers are charging a higher price in a monopoly than they would in an equivalent competitive market, which increases producer surplus. The comparison of producer surplus for a monopoly versus a competitive market is shown above.

So which area is bigger? Logically, it must be the case that producer surplus is larger in a monopoly than in an equivalent competitive market since otherwise, the monopolist would voluntarily choose to act like a competitive market rather than like a monopolist!

Monopoly versus Competition for Society

When we put consumer surplus and producer surplus together, it's pretty clear that competitive markets create a total surplus (sometimes called social surplus) for society. In other words, there is a reduction in total surplus or the amount of value that a market creates for society when a market is a monopoly rather than a competitive market.

This reduction in surplus due to monopoly, called deadweight loss, results because there are units of the good not being sold where the buyer (as measured by the demand curve) is willing and able to pay more for the item than the item costs the company to make (as measured by the marginal cost curve). Making these transactions happen would raise total surplus, but the monopolist doesn't want to do so because lowering the price to sell to additional consumers would not be profitable due to the fact that it would have to lower prices for all consumers. (We will come back to price discrimination later.) Put simply, the incentives of the monopolist are not aligned with the incentives of society overall, which leads to economic inefficiency.

Transfers from Consumers to Producers in a Monopoly

We can see the deadweight loss created by a monopoly more clearly if we organize the changes in consumer and producer surplus into a table, as shown above. Put this way, we can see that area B represents a transfer of surplus from consumers to producers due to monopoly. In addition, areas E and F were included in consumer and producer surplus, respectively, in a competitive market, but they aren't able to be captured by the monopoly. Since total surplus is reduced by areas E and F in a monopoly as compared to a competitive market, the deadweight loss of monopoly equals E+F.

Intuitively, it makes sense that area E+F represents the economic inefficiency created because it is bounded horizontally by the units that aren't being produced by the monopoly and vertically by the amount of value that would have been created for consumers and producers if those units had been produced and sold.

Justification for Regulating Monopolies

In many (but not all) countries, monopolies are prohibited by law except in very specific circumstances. In the United States, for example, the Sherman Antitrust Act of 1890 and the Clayton Antitrust Act of 1914 prevent various forms of anticompetitive behavior, including but not limited to acting as a monopolist or acting to gain monopolist status.

While it is true in some cases that laws specifically aim to protect consumers, one need not have that priority in order to see the rationale for antitrust regulation. One need only be concerned with the efficiency of markets for society overall in order to see why monopolies are a bad idea from an economic perspective.