In this note we evaluate the costs and benefits of businesses with industry muscle, monopoly pricing power in markets. The standard economic and social case against monopolistic businesses is no longer straightforward. Markets are changing all of the time and so are the conditions in which businesses must operate regardless of whether they have any noticeable market power.

The economic case against monopoly

The usual textbook argument against monopoly power in markets is that existing monopolists can continue to earn abnormal (supernormal) profits at the expense of economic efficiency and the welfare of consumers and society.

The standard case against monopoly is that the monopoly price is higher than both marginal and average costs leading to a loss of allocative efficiency and a failure of the market mechanism. The monopolist is extracting a price from consumers that is above the cost of resources used in making the product and, consumers’ needs and wants are not being satisfied, as the product is being under-consumed.

The higher average cost of production if there are inefficiencies in production also means that the firm is not making optimum use of its scarce resources. Under these conditions, there may be an economic case for some form of government intervention to limit or reduce the scale of monopoly power, for example through the rigorous application of competition policy or by a process of market deregulation (liberalisation).

X Inefficiencies under Monopoly

X inefficiency is a term first coined by Harvey Libenstein. The lack of real competition may give a monopolist less of an incentive to invest in new ideas or consider consumer welfare. It can also be argued that even if the monopolist benefits from economies of scale, they will have little incentive to control production costs and 'X' inefficiencies will mean that there will be no real cost savings.

Comparison between Monopoly and Perfect Competition

A competitive industry will produce in the long run where market demand = market supply. Consider the diagrams below. Equilibrium output and price is at Q1 and Pcomp on the left hand diagram and Pcomp and Q1 on the right hand diagram. At this point, Price = MC and the industry meets the conditions for allocative efficiency.

If the industry is taken over by a monopolist the profit-maximising point (MC=MR) is at price Pmon and output Q2. The monopolist is able to charge a higher price restrict total output and thereby reduce economic welfare. The rise in price to Pmon reduces consumer surplus.  Some of this reduction in consumer welfare is a pure transfer to the producer through higher profits, but some of the loss is not reassigned to any other economic agent. This is known as the deadweight welfare loss and is equal to the area ABC.

A similar result is seen in the next diagram which makes the working assumption of constant long run average and marginal costs under both competition and monopoly. The deadweight loss of economic welfare under monopoly (whose profit maximising price is P1 and Q1) is shown by the triangle ABC. The competitive price and output is Pc and Qc respectively.

 

Potential Benefits from Monopoly

It is important in essays and data questions when you are analyzing imperfectly competitive markets where the concentration ratio is high to mention some of the potential advantages of suppliers having monopoly power.

One difficulty in assessing the welfare consequences of monopoly, duopoly or oligopoly lies in defining precisely what a market actually constitutes! In nearly every industry the market is segmented into different products, and the impact of globalisation makes it difficult to gauge the true degree of monopoly power that might exist in an industry at any moment in time. Increasingly markets where a monopoly appears to exist are actually becoming more contestable because of the effects of growing international competition.

So what are the main advantages of a market dominated by a few sellers?

Economies of Scale

A monopolist might be better positioned to exploit economies of scale leasing to an equilibrium which gives a higher output and a lower price than under competitive conditions. This is illustrated in the next diagram, where we assume that the monopolist is able to drive marginal costs lower in the long run, finding an equilibrium output of Q2 and pricing below the competitive price.

Monopoly Profits, Research and Development and Dynamic Efficiency

As firms are able to earn abnormal profits in the long run there may be a faster rate of technological development that will reduce costs and produce better quality products for consumers. This is because the monopolist will invest profits into research and development to promote dynamic efficiency.

Monopoly power can be good for innovation, according to research by Professor Federico Etro, published in the April 2004 edition of the Economic Journal. Despite the fact that the market leadership of firms like Microsoft is often criticised, their investments in research and development (R&D) can be beneficial to society because they expand the technological frontier and open new ways to prosperity. Many technological innovations are developed by firms with patents on the leading-edge technologies. These firms perpetuate their leadership and their market power through innovations. Etro's research argues that providing that a market is characterised by free entry, then the market leader will actually have more incentives than any other firm to invest in R&D.

Baumol – Oligopoly and Innovation

William Baumol an economist from Princeton University in the USA published a book in 2002 “The Free Market Innovation Machine” in which he analysed the conditions best suited for markets and countries to achieve a faster pace of innovation. Baumol argues that the structure that fosters productive innovation best is oligopoly. The Baumol hypothesis is that oligopolists compete by making their products differ slightly from their rivals. Highly innovative firms are often quick to license new technology or to become members of technology-sharing consortia.

Natural Monopoly

A natural monopoly occurs in an industry where LRAC falls over a wide range of output levels such that there may be room only for one supplier to fully exploit all of the internal economies of scale, reach the minimum efficient scale and therefore achieve productive efficiency.

The major utilities such as gas, electricity and water are often put forward as examples of industries with strong "natural tendencies" towards being a natural monopoly in part because of the huge fixed costs of building and maintaining nationwide networks of cables and pipes. In fact we can make an important distinction between the supply and distribution of services such as gas and electricity. The retail market for the supply of gas and electricity to homes and businesses is also fully competitive. However, the businesses which transport gas and electricity to the final consumer are closer to being natural monopolies. The industry regulator Ofgem regulates these companies through price controls and monitoring of quality of service.

The natural monopoly through the exploitation of economies of scale can in theory undercut any actual or potential rivals purely on the grounds of cost. If the monopolist loses market share (for example by the competition authorities acting to split up an existing monopoly) there is the risk that smaller-scale suppliers will produce at higher average total cost which would represent a waste of scarce resources. Forcing such a company to price at marginal cost would also inflict inevitable losses and threaten the long term financial viability of the supplier.