So far we’ve examined a monopoly the same way we would examine a perfectly competitive firm, that is to say we can determine the monopolist’s optimal price assuming they want to maximize profit. The problem with doing this and then just stopping there is that it ignores the negative effects this has for society. In other words, it creates situations in which the monopolist and only the monopolist benefits at the expense of everyone else. This article explains specifically how that happens and more importantly, what can be done about it.
Before proceeding, it’s important to keep the following in mind: the monopoly is the market, they are the industry’s only producers. Thus, the monopolist’s marginal cost curve isn’t simply the firm’s marginal cost (MC) curve (as it would be under perfect competition) but rather, it’s the market’s MC curve. In other words, it’s the market’s supply curve - we can refer to a monopoly's MC to determine how much the market is willing to supply.
Now here we see the inherent inefficiency of monopolies. As we know, a firm, whether it’s monopolistic or perfectly competitive, must produce where marginal revenue (MR) equals marginal cost in order to profit. Under perfect competition, this is where supply and demand intersects, since the MR curve is the demand curve.
As seen in the graph, the equilibrium price under perfect competition would be 5 units selling for $6 each. But monopolies don’t operate here: both their MC and average total cost (ATC) curves exceed their MR, meaning they’re losing money with each additional unit. Remember, produce where MR=MC.
Here we see an obvious gap between the perfect competition and the monopoly equilibrium point, but it’s not what you’d expect. See, most people criticize and fear monopolies on the basis that they set prices far more than what it would’ve been under perfect competition. But as shown above, the opposite is occurring (this isn’t to say that monopolies jacking up their prices isn’t a threat). The real loss is the monopoly not supplying enough output to be allocatively efficient.
Perfect competition is the most efficient a market can be in terms of how it handles resources. In our case, that would be selling 5 units at $6 each. But the monopoly is instead selling only 4 units...but not at $4 each. Rather, the monopoly sells at $7 each. The demand curve is what consumers are paying, and so from the monopoly equilibrium point (not price), we simply go straight up until we hit the demand curve. Thus, the monopoly sells 4 units at $7 each - they are producing less for more.
We refer to the situation presented above as deadweight loss. It’s how economists measure lost economic efficiency when we don’t see the socially optimal quantity of goods being produced.
If our coffee firm was in perfect competition, we would charge $5 for every cup and consumers would purchase them if their marginal benefit exceeded $5. But we, the monopoly, would charge whatever yields the greatest profit and so we decide to price the coffee at $7. This excludes every customer from the market with a marginal benefit less than $7.
We “price out,” so to speak, the potential customers with a marginal benefit of between $5 and $7, thus creating a deadweight loss. This is the qualm economists have with monopolies: they waste scarce resources. The next obvious question is what can be done about this. What the government usually does is impose price ceilings - a limit on how high a price can be charged for a good or service. There are 2 different places the ceiling can be set:
Socially optimal: this is where the monopoly is forced to produce the quantity society wants, which is where marginal cost (remember, interchangeable with supply in this case) intersects the demand curve. The downside to this is that the monopoly is going to be producing at a loss - by producing where MC intersects demand, both the MC and the average total costs (ATC) exceeds the MR.
Fair return: this sets the price ceiling where demand hits ATC, which is slightly lower than before. The reason it’s called fair return is because by pushing the price to that spot, the monopoly is breaking even: they’re not profiting at the expense of the public nor are they making losses.
On a final note, some may be tempted to tax the monopoly, specifically to implement a per-unit tax. This, however, has unintended consequences and could just make things worse. Consider for a moment what a per-unit tax rate would do to any company’s costs - it would increase them. And because it’s a per unit cost, we know that the marginal cost (MC) is going to increase. Remember the golden rule: always produce where MR = MC. If the latter goes up, so will the price, as demonstrated below.
The monopoly is now selling 2 units at $9 each; not exactly an improvement.
Well folks, it seems that our analysis on the monopoly firm has come to a close. To summarize:
The MR and demand curve are separate under a monopoly, with the former being more downwards sloping than the latter
The monopoly is the market, meaning its MC curve also serves as the market’s supply curve
All this leads to monopolies having inherent inefficiencies known as deadweight loss, in which they produce less but charge more than what would be under a perfectly competitive market
‘Till next time,
SoBasically