Consistent Comparisons between Monopoly and Perfect Competition
Author(s): Susan E. Skeath, Ann D. Velenchik, Len M. Nichols, Karl E. Case
Source: The Journal of Economic Education, Vol. 23, No. 3 (Summer, 1992), pp. 255-261
Published by: Taylor & Francis, Ltd.
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Consistent
Monopoly
Comparisons Between
and
Perfect
Competition
Susan E. Skeath,AnnD. Velenchik,LenM. Nichols,
and KarlE. Case
Expositionof the social welfareconsequencesof monopolypoweris one
of the centralfeaturesof coursesin intermediatemicroeconomics.This expositionis basedon a purelyillustrativecomparisonof monopolyoutcomes
withthe outcomesof competitivemarketstructures.At its best, this exercise
providesan occasionto discussboth the specificcosts of monopolyand the
basic methodologyof welfarecomparisons.The main insightthat students
welfarecomparisonis, simply,
shouldtake fromthe competition-monopoly
that monopoliestend to produceless output and chargemore for it than
would a benchmarkperfectlycompetitiveindustryand that this type of
equilibriumleadsto a deadweightwelfareloss. Unfortunately,the contrived
natureof this comparisongives rise to inconsistenciesthat may leave students feelingconfused ratherthan informed.The purposeof this articleis
to identify the major inconsistenciesin some standardtreatmentsof the
perfect competition-monopolywelfare comparisonand to suggest more
consistentand productivepedagogicalapproaches.
To be effective, the welfarecomparisonexercisemust not only be internally consistentbut must also conform with what studentslearnelsewhere
in a standardintermediatetheory course. Althoughthe followinganalysis
willindicatewaysin whichthe exercisecan be formulatedto addresseach of
these issues, any useful approachmust includeexplicitidentificationof all
underlyingassumptions.A cleardelineationof how the experimentis constructedis often absent from textbook treatments,and this omissionlimits
the usefulnessof the methodologicalaspectof the exercise.
The standardtextbook illustrationused for the welfarecomparisonbetweenperfectcompetitionand monopolyappearsin Figure1.' The diagram
shows an upward-slopingmarginalcost curve for the monopolist(MCO),
whichis the sum of short-runsupplycurvesfor firmsin a benchmarkperfectly competitiveindustry(SR Sc). The diagramillustratesthe loss of both
producerssurplus(areaB) and consumersurplus(areaA) resultingfromthe
decisionto produceless output and charge
monopolist'sprofit-maximizing
a higherpricethan would be the case underperfectcompetition.The monSusanE. SkeathandAnn D. Velenchikareassistantprofessors,Len M. Nicholsis an associate
professor,and KarlE. Case is a professorof economicsat WellesleyCollege. The authors
wouldlike to thankHirschelKasperand two anonymousrefereesfor helpfulsuggestionson an
earlierversionof this article.
Summer 1992
255
FIGURE1
The StandardApproach
P
MC m
SR Sc
P
PS
m
A
P
--
----
C
B
Demand
MR
Qs
(AR)
Q
from
A = lostconsumer
surplus
monopoly.
B == lost
frommonopoly.
lost producer
surplusfrom
producersurplus
monopoly.
opolist's marginalcost curve in Figure 1 is the primarysource of the two
types of inconsistenciescommonlyfound in the welfarecomparison.The
internalconsistencyproblemcentersaroundthe appropriatetime horizon
(short or long run) over which the experimentshould be constructed.The
externalconsistencyprobleminvolvesthe implicationsof alternativeslopes
of the monopolymarginalcost curvefor other issuesraisedin intermediate
microeconomicscourses.
INTERNAL CONSISTENCY: THE TIME HORIZON
To maintaininternalconsistency,teachersneed to clarifythe time horizon for students when introducing the monopoly-competition welfare com256
JOURNAL OF ECONOMIC EDUCATION
parison.It is well knownthat this comparisonshouldinvolvelong-runequilibriumpositions. Use of a short-runcompetitiveequilibriumimpliesthat
furtherexit or entrymay occur in the industry,makingthe welfare-losscalculation valid for only the period of time that the equilibriumexists. Because the monopolyequilibriumis the same in the short and the long run,
becauseof the existenceof insurmountableentry barriers,it is naturalto
compareit to the long-runcompetitivesolution. Monopolymarginalcost is
commonly accepted to be representedby the sum of the marginalcost
curvesof the individualcompetitivefirms.Thus, if we wantto comparethe
monopoly outcome to the long-runperfectlycompetitiveoutcome, and if
we want to be as consistent as possible, teachersof intermediatetheory
should be using the long-runcompetitivesupplycurveas an equivalentfor
the monopolist'smarginalcost curveand, thus, for the appropriatewelfare
comparisonbetweenmonopoly and perfect competition.Further,because
demandalso varieswithtime, consistencyarguesfor use of the long-rundemandcurve.
EXTERNAL CONSISTENCY: SHAPE OF THE CURVE
Use of the long-runcompetitivesupply curve as the relevantmarginal
cost curve for the monopolist along with the long-rundemandcurve addressesthe time-horizonconcernveryeffectivelyand resultsin an internally
consistentexperiment.However,the issue of the appropriateshape for the
marginalcost curve, and thus of externalconsistency,remains.The longrun competitiveindustrysupplycurvecould be presentedas eitherupward
sloping or horizontal(i.e., perfectlyelastic). The first approach,although
more general, involves a potential contradictionwith anothermaintained
hypothesisin standardcourses:that perfectcompetitionamongfirmsleads
to zero profitsin long-runequilibrium.The second, simpler,approachimplies no contradictionbut does requiremeticulousexpositionof the particularlystrongassumptionsthat must be madeabout the natureof costs in
the industryin question.
An upward-sloping,long-run,competitiveindustrysupplycurve creates
the necessityfor an explanationof the existenceof long-runexcessprofits
(i.e., producersurplus)in the competitiveindustry.Most texts, when illustratingthe welfarecomparison,depict a situationin whichthe competitive
industryearnssignificantproducersurplus,a concept often explainedas a
combinationof firmprofit and economicrent.2The comparisonin this case
would appearas in Figure2.
The rigorousapproach illustratedin Figure 2 uses the long-run competitive supply curve (LR Sc) as the monopolist's marginalcost curve
(MCr),leadingto an output levelof Qr and a priceof Pr. Deadweightwelfare loss in this case consistsof areasA + B. Note that the long-runcompetitivesupplycurvein Figure2 is flatterthan the short-runcurvein Figure
1 because of the increased flexibility accorded to firms in the long run in the
absence of any fixed factors of production. The positive slope of the curve
Summer1992
257
FIGURE2
RigorousApproach
P
pr
pm
r
r
..MCm
LR Sc
A
Pc
B
Demand
(AR)
MR!
Qr
m
Qc
Q
A = lost consumersurplusfrommonopoly.
B = lost Recardianrentsfrommonopoly.
comes from assumingeither that the competitiveindustryis an increasing
cost industryor that differentialcosts existacrossfirms.3
studentsoften questionthe inconWe have found that intermediate-level
sistencyinherentin the illustrationof a competitiveequilibriumwith positive profits. If we are supposedto be looking at a long-runcompetitive
(zero profit)equilibrium,then how can we justifya welfare-losscalculation
that includesa loss of "producersurplus"(areaB in Figure2)?
The resolutionof this apparentcontradictionrequiresa carefulpresentation of the reasonsfor the existenceof producersurplusin a long-runequilibrium.Clearly,the assumptionsthat generatedthe upward-sloping
supply
curve must be made explicitso that the excess profit can be explainedas
pure Ricardianrent accruingto infra-marginalfirms from locational or
258
JOURNAL OF ECONOMIC EDUCATION
FIGURE3,
ConstantReturns/Constant
CostsVersion
P
P
A
MC m
P
Sc
SLR
Demand
(AR)
MR
Qm
Qc
Q
A = lost consumersurplusfrommonopoly.
nonreproducibleproductiveefficiencyadvantages.Givenscarce"most efficient" productiveunits, diseconomiesof scaleexist, and the marginallongrun disincentivefor entry into the competitiveindustryis preserved.The
deadweightloss of monopolyin the rigorouscase illustratedin Figure2 can
be explainedin just this manner.This approachrequiresthat a significant
amountof time be spent on preciseexplanationsof the conceptsof Ricardian rent and efficiency.Becauseexamplesof industrieswith scarce"most
efficient" productiveunits are more plentiful in the real world than examples of industrieswith homogeneousfirms, this approachmay well be
quite intuitivefor some students.
The alternativepresentationof the monopoly marginalcost curve assumesthat constant returnsto scale exist in the long run. In such a situaSummer 1992
259
tion, the long-runcompetitivesupplycurve,and thus the monopolist'smarginal cost curve, would be horizontaland there would be no contradictory
message about the existence of profits in a long-run competitiveequilibrium.4This approachis illustratedin Figure3, in whichthe entiresocial
welfareloss of monopolycomprisesconsumersurplus(areaA). An explicit
acknowledgmentthat constant returnsto scale imply constant long-run
averageand marginalcosts should precedethe explanationof the welfare
result. The welfare-losscalculationis made more straightforward
with this
simplerhorizontalsupplycurve.
The centralissue, then, is whetherto use an upward-sloping,long-run,
competitiveindustrysupplycurve and maintainconsistencyby includinga
discussionof Ricardianrents or to use the horizontalversionof the longrun supplycurveand sacrificesome generality.The basicsubstantiveresult,
that monopoliesproducetoo little and chargetoo much, can be derivedusing eitherapproach.The upward-slopingcurveand the Ricardianrent discussion, however,create a complexpresentationof a resultthat could be
understoodjust as easily(if not moreeasily)usingsimplerassumptions.For
this reason, use of the horizontallong-runsupplycurve may be the most
satisfactorypedagogicalapproachfor the averagestudent.
The most thoroughapproach,whichshouldbe easilyunderstoodby more
sophisticatedstudents, would be to present the horizontalmarginalcost
case to illustratethe basicpoint and to follow this discussionwith the more
curve.Thismethodhas the addcomplexcase involvingthe upward-sloping
ed advantageof demonstratingthe role of assumptionmakingin economic
analysisratherclearly.It thereforeenhancesthe usefulnessof the exerciseas
a demonstrationof economicmethodology.
CONCLUSION
Ourbriefreviewof severalwidelyused intermediatetextbooksindicatesa
numberof differentviews on how to presentthe welfarecomparisonbetween monopoly and perfect competition.5However,if one considersthe
implicit assumptionsmade in the standardwelfare-lossillustrationcontradictionsclearlyexistin some of these presentations.The use of the shortrun competitivesupplycurveto representthe long-runmonopolymarginal
cost curveis clearlyinappropriate,as is the tendencynot to make underlying assumptionsexplicit. Intermediateeconomics students would benefit
from a more straightforward
and explicitanalysisof the socialcost of monbased
on
a
opoly
comparisonbetweentwo long-runequilibriaundercomconditions.
We believe that the long-runcompetitivesupply
parablecost
curve comprisesthe relevantlong-runmonopoly marginalcost curve, and
this curveshould be representedin the standarddiagram.We also recommend the (explicit)assumptionof constantreturnsto scale in the long run
for the welfarecomparisonswhen the goal is to illustratesimplythe basic
source of social welfare loss under monopoly. Inclusion of the more complex case involves an upward-sloping, long-run, competitive supply curve
260
JOURNAL OF ECONOMIC EDUCATION
and a discussionof Ricardianrent allows studentsto understandthe basic
sourcesof the socialcost of monopolywhilealso providingthem with valuable insightinto some basicissuesin economicmodelingand methodology.
NOTES
1. One shouldmakeexplicitthe assumptionthat the monopolistand the groupof competitive
firmsthat makeup the industryin the comparisonhaveaccessto the sametechnologyand
face the sameinputprices.
2. A numberof textbooksdefineproducersurplusas that portionof the paymentfor a good
or servicethatexceedsthe minimumamountneededto coverthe costsof production(Eaton
and Eaton 1991,266; Friedman1990, 116-17;Hyman1986,267-68;Katzand Rosen 1991,
142-43;Kohler 1990, 196; Maddalaand Miller 1989, 261; Varian1990, 262-63). Others
defineit as relatedto economicrentand firmprofit(Pindyckand Rubinfeld1989,291-92),
whilestillothersgivea cursoryexplanationbasedon the conceptof "economicsurplus"or
simply leave it out completely (DeSerpa 1988, 37-39; Call and Holahan [1983] and
Nicholson[1989]do not defineproducersurplus).
3. Nicholson(1987, 296) defines an increasingcost industryas one "in which the entryof
firmsincreasesthe costs of the firmsin the industry."Entryinto suchan industryimposes
an "externalcost" on existingfirms,drivingup inputpricesand costs of production.Differentialcosts acrossfirmsmay arisefromdifferencesin locationor in accessto scarcefactors of production.Suchan assumptionis consistentwiththe existenceof Ricardianrentin
competitiveequilibrium.Eitherof these assumptionsis sufficientfor the existenceof an
upward-sloping,
long-run,competitivesupplycurve.
4. Nicholson'stextbooks(1987, 1989)use constantmarginalcosts in the illustrationsof the
socialcost of monopoly.They do not, however,identifythe assumptionsimpliedby these
diagrams.
5. All of the texts use an upward-slopingcompetitivesupply curve as the monopolist's
marginalcost curve,exceptfor the two by Nicholson.None of the textsexplicitlydiscusses
the need for dealingwith the long-runcurveand none explicitlyaddressesthe assumptions
madein the developmentof the welfarecomparison.
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