A2/IB Why do Monopolies Cause a Deadweight Loss?
A2/IB Why do Monopolies Cause a Deadweight Loss?

#### Summary

A simple definition would be that a monopoly is just a market where there is only one seller. However, monopolies must be well understood, in order to understand why they are so harmful. In this LP we learn about monopolies, starting with a few basic definitions and starting to learn about a few types of monopolies.

• Monopoly
• Surplus
• Lerner index

#### Types of monopolies:

Monopoly (from the greek «mónos», single, and «polein», to sell) is a form of market structure of imperfect competition, mainly characterized by the existence of a sole seller and many buyers. This kind of market is normally associated with entry and exit barriers.

All of these features give the monopolist the ability to set prices with the only limitation of consumers’ willingness to pay. Therefore, in monopolies, the seller is a price-maker and consumers will be price-takers. The firm will choose its production output (q) and price (p) in order to maximise revenue (π). The optimal condition, where we’ll have marginal cost (MC) equals marginal revenue (MR), is given by:

The extent to which a firm can take advantage of its monopolistic condition will highly depend on the flexibility of its demand curve. If it is more rigid (steeper), it will only have to reduce its production in order to achieve a higher price. However the more flexible (flatter) the demand curve is, the less market power the firm has to increase prices. This relationship between price elasticity of demand and market power can be described using the Lerner index. This index measures the firm’s level of market power by relating price to marginal cost,

The result will always be between 0 and 1: the closer it is to 0, the closer it is to perfect competition; the closer it is to 1, the higher market power the seller has and hence closer to a monopoly. A monopolist seeking to maximise profits will never be on the inelastic part of the demand curve, E < 1, which is why elasticity will always be such as ∞ ≥ E ≥ 1. The Lerner index is equivalent to the inverse of the elasticity in its absolute value faced by the firm when price is set to maximise profits.

The implications of monopolies in terms of loss of efficiency and social welfare have been largely studied and discussed. If we compare the monopolistic price setting with the perfect competition one, we will find that while in the former price is greater than marginal cost, in the latter, they are equal. This implies that in general, price will be higher and output lower, if a firm behaves in a monopolistic manner, instead of a competitive one. And also in general, results for the firms will be to be better off, while it will be just the opposite for consumers. However, the gain for the firm will not sum up the total loss for the consumers. This is known as the deadweight loss of monopoly that comes as a result of the Pareto inefficiency of monopolies. From the equilibrium output of a monopoly to that of a perfectly competitive market, the consumers will be willing to pay more than marginal cost. This leaves space for improving efficiency, but monopolistic firms choose to produce less and set higher prices. This deadweight loss is represented by the areas A and B in the adjacent figure: while the monopolist gains area Cˈ and loses B, consumers transfer area Cˈ and lose A. As a result, firms increase their surplus, consumers lose part of it and in aggregate terms, society as a whole, will bury the deadweight loss.

Types of monopolies:

As we have previously explained, monopolistic firms maximise their profits with the level of output in which marginal cost equals marginal revenue. However we can distinguish different types of monopolies depending on how they achieve this. We can distinguish different types of monopolies:

Multiplant monopoly: firms which have many production plants and hence different marginal cost functions will have to choose the individual output level for each plant.

Bilateral monopoly: this market structure consists of a single buyer (monopsony) and a single seller (monopoly). Depending on who has greater negotiation power there can be different outcomes. Two possible scenarios may be in either one of them having all of the power, an intermediate solution may be found or a vertical integration may occur.

Multiproduct monopoly: instead of selling one product, the monopoly sells several. The firm will have to take into account how the changes in the price of one affect the rest of its products.

Discriminating monopoly: firms may want to charge different prices to different consumers, depending on their willingness to pay. Depending on the level of discrimination we have different degrees. The first degree or perfect discrimination is given when the monopolist sets the highest price that each consumer is willing to be pay. The second degree or nonlinear price fixing is given when price depends on the amount bought by the consumer. And finally, the third degree or market segmentation of price discrimination occurs when there are several differentiated consumers segments to which the firm will apply different prices, e.g. student or third age discounts.

Natural monopoly: this kind of monopoly occurs in industries in which, due to cost-technological factors, it is more efficient to have a single firm dealing with all of the production, as average costs are lower in the long run; a phenomenon known as subadditivity.

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