This essay will look at efficiency between both a monopoly and a perfect competition, and whether a monopoly is necessarily less efficient than perfect competition. Using diagrams and equations reflecting the optimal choice of output, marginal revenue and marginal cost for monopolies, I will explain how efficiency is affected by low levels of production. At the same time monopolies can increase efficiency due to their ability in price discrimination, they price people differently and therefore people pay what they truly believe the good is worth.
There needs to be a clear description of the differences between monopoly and perfect competition as well as efficiency; an analysis of deadweight loss and natural monopoly is also important with regards to the monopolies efficiency. Therefore even though a competitive economy is efficient and a monopoly suffers from certain inefficient levels of production it is not necessarily less efficient than perfect competition. A monopoly is a single supplier within a market that chooses to produce at any point on the market demand curve; they appear when other firms find it unprofitable or impossible to enter a market.
The market becomes affected by high barriers to entry, which are split into technical and legal barriers. Technical barriers are created when the production of a good produces decreasing marginal and average costs over a wide range of output levels; in this situation, large scale firms are low cost producers. Another technical barrier to monopolies is their ability to discover a low cost production technique and having ownership over productive resources therefore preventing the formation of other firms.
Legal barriers occur when a monopoly is created by the government as a matter of law, there is the creation of a patent that allows the one firm to use the basic technology for a product. Varian describes how monopolies arise within his writings, he states that monopolies develop when the minimum efficient scale is large relative to the size of the market, then the industry becomes a candidate for regulation or other forms of government intervention. A second way a monopoly may arise is when a number of different firms in an industry collude and restrict output in order to raise prices and therefore increase their profits.
This form of industry is referred to as a cartel (Varian, 1996, p. 418-419). From this we can see that if demand is large relative to the MES (minimum efficient scale) a competitive market will arise, if it is small, a monopoly structure is possible. This is influences by both the technological level and economic policy influencing the size of the market. Before we analyse the efficiency of monopolies in comparison to perfect competition, it is necessary to set the basis of measurement for both the monopolies and perfectly competitive firms.
This is set out in the First Theorem of Welfare Economics; which explains the relationship between perfect competition and the efficient allocation of resources. Attaining a Pareto efficient allocation of resources requires that the rate of trade off between any two goods should be the same for all economic agents. In a perfectly competitive economy, the ratio of the price of one good to another provides the common rate of trade off to which all agents will adjust. Because all agents face the same prices, all trade off rates will be equalised and an efficient allocation will be achieved (Snyder and Nicholson, 2005, p.
471). Varian however states that the First Theorem of Welfare Economics says nothing about the distribution of economic benefits; market equilibrium might not be a “just” allocation (Varian, 1996, p. 510-511). Therefore in essence the Theorem states that a competitive economy is efficient, if a monopolist behaves non-competitively then he is behaving inefficiently. It is seen that monopolies create a Pareto inefficient level of production, relative to perfect competition; monopoly involves a loss of consumer surplus for demanders.
Some of this is transferred into monopoly profits, whereas some of the loss in consumer surplus represents a deadweight loss of overall economic welfare. Snyder and Nicholson describe Pareto efficient allocation as an allocation of resources, where it is not possible through further reallocations to make one person better off without making someone else worse off (Snyder and Nicholson, 2005, p. 467). Varian further explains that a competitive industry operates where price equals marginal cost, while a monopolised industry operates where price is greater than marginal cost; therefore a higher price creates a lower output (Varian, 1996, p.411-412). [pic]
From the diagram above we can see that if we get the firm to behave as a competitor and take the market price as being set exogenously. Then we would have (Pc, Yc) for competitive price and output. If the firm recognised its influence on the market price and chose its level of output so as to maximise profits, we would see monopoly price and output (Pm, Ym). Since P(y) is greater than MC(y) for all the output levels between Ym and Yc, there is a whole range of output where people are willing to pay more for a unit of output than it costs to produce it.
Clearly there is potential for Pareto improvement (Varian, 1996, p. 412-413). A measure of efficiency can be produced by analysing the total surplus for a given market; this is seen by subtracting the total cost from gross consumption benefits. The higher the level of total surplus the more efficient production becomes. If perfect competition leads to an efficient output level and a monopoly leads to less output then perfect competition, it must therefore be less efficient since the monopolist produces less than the total surplus maximising level of output.
Areas B and C represent the deadweight loss of a monopoly. As we move from the monopoly level of output to the competitive level of output we “sum up” the distances between the demand curve and the marginal cost curve to generate the value of the lost output due to the monopoly behaviour (Varian, 1996, p. 414-415). The loss arises because consumer gain from increasing output is larger then marginal cost but monopolies are not able to produce more. The output produced by a monopoly may not be the only thing brought up into question; quality is also an important factor regarding the efficiency of a monopoly.
Whether a monopoly produces a higher or lower quality good than would be produced under competition depends on demand and the firm’s costs. The difference between the quality choice of a competitive industry and the monopolist is that the monopolist looks at the marginal valuation of one more unit of quality assuming that output is at its profit maximising level. The competitive industry looks at the marginal value of quality averaged across all output levels. Even if they were to both opt for the same output level, their quality preferences may be different.
John Jewkes gives an explanation of the grounds upon which a single producer monopoly would defend its cause. The case was raised by the British Oxygen Company Ltd, which produced four points for its protection. The monopoly itself was achieved purely as a result of efficiency; the monopoly supply within the industry is more efficient than any other arrangement. With capital equipment being extremely costly and transport charges high, there would either be a duplication of equipment keeping costs up or there would be many local monopolies catering for local markets.
The company had kept its prices and profits without exploiting its monopoly position, as well as keeping a strong record in research and technical progress. In this case the commission discovered that the monopoly was using its position to charge higher prices, however they accepted that there might be technical advantages in the creation of monopolies (Jewkes, 1958, p. 16-17). It seems as though there will need to be a form of regulation so as to create monopolies which keep to the efficient level of production.
Technically all the regulator has to do is set price equal to marginal cost, and profit maximisation will do the rest. However, this analysis leaves out the fact that it may be that the monopolist would make negative profits at such a price. [pic] Here the minimum point of the average cost curve is to the right of the demand curve, and the intersection of demand and marginal cost lies underneath the average cost curve. Even though the level of output Ymc is efficient, it is not profitable. The natural monopolist will be unable to cover its costs and therefore run out of business.
If the government was to regulate it then a point such as (Pac, Yac) would be a natural operating position. Here the firm is selling its product at the average cost of production, so it covers its costs, but it is producing too little output relative to the efficient level of output. The government may interfere and operate the natural monopoly, they let it operate where price equals marginal cost and provide a subsidy to keep the firm in operation; however it may be viewed that subsidies represent inefficiency (Varian, 1996, p. 416-418).
Governments often choose to regulate natural monopolies which can affect the behaviour of regulated firms and may not necessarily lead to an efficient outcome. The idea that competitive pressures produce maximum technical efficiency may not necessarily be true; competition does not guarantee that inefficiency will not arise. The assumptions that surround perfect competition and their production of maximum technical efficiency include; firms maximising profits, they have complete knowledge of available techniques and associated costs and that there is free entry.
The first two assumptions apply to monopolies and perfect competition, the final assumption states that free entry guarantees maximum technical efficiency. However at best free entry guarantees a higher level of efficiency; this is because it eliminates inefficient firms. It is not a suitable explanation for superior efficiency, since there may be other sources of efficiency, including scale economies which favour monopolies (Schwartzman, 1973, p. 759-762). There can be greater efficiency from a monopoly if we were to take price discrimination into account.
Price discrimination is the practise whereby different buyers are charged different prices for the same good. It is a practise which cannot prevail in a competitive market because of arbitrage: those offered lower prices would resell to those offered higher prices and so a seller would not gain from discrimination. Its existence therefore suggests imperfections of competition (Gravelle and Rees, 1992, p. 274). A monopoly engages in price discrimination if it is able to sell otherwise identical units of output at different prices.
If the firm is able to identify and separate each buyer, they may be able to charge each buyer the maximum price they would be willing to pay for each good; this is referred to as perfect or first degree price discrimination which extracts all consumer surpluses and creates no deadweight loss. In first degree price discrimination the monopolist can extract all the consumer surplus of each buyer. Total output of the good is at the level at which each buyer pays a price equal to marginal cost; thus we have the “competitive outcome”.
Monopoly does not distort the allocation of resources, and so we have a Pareto efficient outcome, with the monopolist receiving all the gains from trade. Any objection to monopoly would therefore have to be on the grounds of equity, fairness of the income distribution rather than efficiency (Gravelle and Rees, 1992, p. 276). It is evident that price discrimination produces a more efficient outcome since buyers are paying the amount which they believe the good is worth. If one buyer wants the good more then another then he should be willing to pay more for it.
It is extremely difficult for a monopoly to separate each individual buyer; a less stringent requirement would be to assume that the monopoly can separate its buyers into a few identifiable markets. This third degree price discrimination requires the monopoly to know the price elasticity’s of demand for each market, and set price according to the inverse elasticity rule. MC= (a) (b) We let ei and ej be the price elasticity’s of demand in the respective sub markets, equation (b) therefore comes out of a re-arrangement of equation (a).
If ei=ej, then clearly there will be no discrimination, but there will be as long as the elasticity’s are unequal at the profit maximising point. We can see that in maximising profit the monopolist will always set a higher price in the market with the lower elasticity of demand (Gravelle and Rees, 1992, p. 274-275). All the monopolist needs to know is the price elasticity of demand for each market and set price according to the inverse elasticity rule. In conclusion it is evident that monopolies create inefficiency due to the low output levels which they produce at.
A monopoly produces at a level where price is greater then marginal cost and therefore its output is reduced, in comparison to perfect competition where price is equal to marginal cost. Taking regulation into account still means that a monopoly is inefficient since it is being supported by subsidies from the government. However perfect competition is not necessarily more efficient then a monopoly firm, when looking at the basic assumptions of perfect competition in terms of efficiency, we can see that a difference arises due to free entry within the market.
It is easy to assume that just because there is free entry it means that firms are forced to reach their highest point of efficiency, there is an increase however the maximum is not guaranteed. At the same time if a monopoly price discriminates it can achieve strong levels of efficiency. Therefore a monopolist is not necessarily less efficient than firms within perfect competition. C B Pm Pc Ym Yc MR Demand MC Output Price AC MC Demand Output Price Pac Pmc Yac Ymc Losses to the firm from marginal cost pricing [pic] [pic].