Chapter 30: Monopoly vs. perfect competition
(1.5)
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


Disadvantages of monopolies
Efficiency in monopolies and perfectly competitive market firms
And yet...
Regulating monopoly power
Monopoly and
•
Explain, using diagrams, why the profit
efficiency
The advantages
and disadvantages
of monopoly
compared with
perfect
competition
maximizing choices of a monopoly firm lead to
allocative inefficiency (welfare loss) and
productive inefficiency
Schumpeter
and
creative
destruction
– pic of
buggy at
Cuervo
Hacienda
Policies to
regulate monopoly
power
•
Explain why, despite inefficiencies, a monopoly
may be considered desirable, for reasons
including the ability to finance research and
development (R&D) from economic profits, the
need to innovate to maintain economic profit
and the possibility of economies of scale
•
Draw diagrams and use them to compare and
contrast a monopoly market with a perfectly
competitive market with reference to factors
including efficiency, price and output, research
and development and economies of scale
•
Evaluate the role of legislation and regulation in
reducing monopoly power
It’s fairly safe to say that monopolies have a rather poor reputation amongst both us consumers and also the
political entities we elect to safeguard our interests. But the full story, as so often is the case, shows that
monopolies in fact have a number of advantages – sometimes outweighing the disadvantages. The ability to
compare different market structures using economic jargon and diagrammatical illustrations is the MOST
important component of theory of the firm. Simply committing a number of diagrams to memory will not
enable you to address the analytical questions posed in the IB exams – you must be able to utilise the
concepts and diagrams to explain, assess and analyse the world around you. Study this section carefully.

Disadvantages of monopolies
In comparing the perfectly competitive firm/market with the monopolistic firm, we must make a few
additional assumptions. This is not done in order to ‘make the diagrams work’ as some of my ‘snottier’
students claim, but to enable us to compare apples with apples, rather than apples with oranges. We make
two assumptions in addition to those previously outlined:
1.
The sum of the perfectly competitive market’s MC curves are identical to the supply-curve on the
perfectly competitive market and also to the monopoly’s MC curve; ΣMCPCM firms = SPCM =
MCmonopoly. This is not as outlandish as first sight might indicate. Consider a competitive market
where all firms are efficient and operating along the best possible MC curves and that one large firm
buys up all the individual firms. The large monopoly runs each separate firm as a plant belonging to
the mother company – the MC remains the same, since we also assume that…
2.
…there are no benefits of scale involved. If there were, we could not assume that
ΣMCPCM firms = MCmonopoly, as the monopoly would gain scale benefits and thereby lower both AC and
MC.
(Type 4 Smaller heading) Higher price and lower output
It follows common sense that a firm which can affect supply but not demand will set a price which will
optimise profit by way of increasing the margin (= distance) between the market price and the firm’s costs.
This is done by restricting output and setting the price above marginal cost. Figure 2.3.37 shows that a
monopoly will have a different outcome in terms of price and output. The MR curve for the monopolist will
be lower than demand at all levels which sets the MC = MR point at lower output than would be the case in
a competitive market. Note that the monopoly MC curve is the sum total of all PCM firms ’ MC curves,
which means that the supply curve for both the competitive market and the MC curve for the monopoly are
one and the same.
Fig. 2.3.37 The PCM firm compared to a monopoly
PCM firm
P, costs
PCM
P, costs ($)
P ($)
($)
MCPCM firm
PPCM
Monopoly
ΣMCPCM firms
Pmon
= SPCM
AR, MR, D
Q/t
QPCM firm
MR
Monopoly
outcome
ΣMCPCM firms =
SPCM = MCmon
PCM
outcome
PPCM
D
QPCM
Q/t
D, AR
Qmon QPCM
Q/t
As the monopoly restricts market output and raises the price, the producer gains at the expense of the
consumers. This loss of consumer sovereignty is the most noticeable negative effect of monopoly market
situations; consumers ‘pay more for less’. See below for more depth in Outside the box: Monopolies and
deadweight loss.
OUTSIDE THE BOX: MONOPOLIES AND DEADWEIGHT LOSS
I do apologise if the additional theory in these boxes weigh you down by seemingly adding to
your already considerable workload. My justification is that I am trying to provide you with a
set of tools which will enable you to better address the questions you will face in the field of
economics. Being able to use the concept of consumer/supplier surplus to show dead-weight
loss is quite valuable.
Recall that the PCM will result in optimal allocative efficiency since total consumer and
supplier surplus will be maximised. The diagrams in figure 2.3.38 below illustrate what
happens when a monopoly supplies the market rather than competitive firms. (Note the
assumption of PCM supply = monopoly’s MC curve!) The right diagram shows that when the
PCM provides the good at PPCM and QPCM, consumer and supplier surplus are maximised –
any other price would lower total societal surplus.
Fig. 2.3.38 Deadweight loss in a monopoly
P ($)
PCM
P ($)
Consumer surplus
Monopoly
Loss of consumer
surplus
S
MC
Pmon
PPCM
Monopolist’s gain;
“appropriation” of
consumer surplus
PPCM
D
QPCM
Q/t
Supplier surplus
D
MR
Qmon QPCM
Loss of
supplier
surplus
Q/t
Net loss of consumer and supplier
surplus = deadweight loss.
When a monopoly provides the good, the price rises to Pmon and market quantity falls to
Qmon whereby the monopoly firm “appropriates” a portion of consumer surplus (light red
area). Furthermore, both the consumers and suppliers lose a portion of their surplus (green
and blue triangles respectively). These triangles show that at each level of output lost, the
potential benefits (shown by the D-curve) outweigh any increase in cost (shown by the MC
curve). This is a welfare loss to society commonly termed a deadweight loss.
The PCM has no deadweight loss and is therefore allocatively efficient. The monopoly’s
deadweight loss illustrates that it is not allocatively efficient.
(Type 4 Smaller heading) Predatory pricing
One way to create and/or uphold a monopoly is simply to get rid of rivals and dissuade (= discourage)
potential entrants to the market. A monopoly has the market power to price at a lower level than potential
entrants can set. This pricing policy is short run, as it is intended to kill off rivals (hence the term
“predatory pricing”) so that the monopoly can maintain profitmax pricing and abnormal profits.
Fig. 2.3.39 Predatory pricing in monopoly
P, costs ($)
MCpotential
MC
PΠ-max
AC
Pmin
MR
QΠ-max
The monopoly firm can set the
price as low as Pmin. This is the
break-even point, i.e. where AC
= AR. The monopoly would
make a normal profit. Potential
entrants cannot match this
price, which dissuades market
entry.
D, AR
Q/t
Qmax
Suppose that the most efficient potential competitor(-s) could attain a marginal cost of MCpotential, shown in
figure 2.3.39. This would be competitive with the monopolist’s profitmax price of PΠ-max. The monopoly
might therefore lower its price and accept a lower abnormal profit margin. Indeed, it is quite possible for
the monopoly to set the price where AC = AR, i.e. the break-even point of output. It is worthy of
mentioning that many countries’ anti-trust laws strictly forbid any type of predatory pricing.
(Type 4 Smaller heading) Limiting competition
A monopoly can protect its captive market from possible entry in a number of ways. It can refuse to sell
monopolised parts to potential competitors, which is what Microsoft did in the late 1990s when the
company refused to sell Windows to computer manufacturers which did not also accept the Web browser
Explorer, which ultimately cost the leading browser at the time, Netscape, most of its market share. In
essence, a monopoly can seek to block/hinder rivals’ access to supply-chains in production and retail/outlet
chains at the sales end of operations. Monopolies also wield considerable financial and political power,
which can create a ‘cosy’ relationship with governments which not only are consumers of monopoly goods,
but are also responsible for regulating monopolies. Monopolies are also interested in setting the end-user
price (i.e. the retail price) and can therefore attempt to force retailers to set prices which are noncompetitive.
(Type 4 Smaller heading) Higher costs and less innovation
It is possible that a monopoly firm may choose ‘the quiet life’1 , i.e. be satisfied with a comfortable level of
abnormal profit rather than putting effort into increasing efficiency. This profit saticficing outcome would
1
Description of monopoly by Nobel laureate J. R. Hicks. web.mala.bc.ca/econ/quotes.htm
be suboptimal, since productivity increases would be less than in a perfectly competitive market.

Efficiency in monopolies and perfectly competitive market firms
We again include the assumption that the sum of PCM firms’ marginal costs equals PCM market supply
and also the MC curve of a monopoly, e.g. the monopoly does not have economies of scale. Figure 2.3.42
below compares the cost pictures for a firm operating on a competitive market and a monopoly market.
Fig. 2.3.42 Efficiency in monopoly and the PCM
P (AR) > MC; the monopoly is not
allocatively efficient.
PCM firm
PCM
Monopoly
P, costs ($)
P ($)
P, costs ($)
MCPCM firm
ΣMCPCM firms
Pmon
= SPCM
MR
ΣMCPCM firms =
SPCM = MCmon
AC
PPCM
AC
AR, MR, D
Q/t
QPCM firm
● Output level is at ACmin;
there is productive efficiency.
PPCM
D
QPCM
Q/t
D, AR
Qmon QPCM
Q/t
Output level is not necessarily where
AC is minimised; suboptimal
productive efficiency.
● P (AR) = MC; there is
allocative efficiency.

PCM firm: Recall that the long run equilibrium of the competitive market is when each PCM firm
is operating at the lowest possible average cost (ACmin) and where the price of the last unit is equal
to the cost of the last unit (P [MR] = MC). The PCM firm is therefore both productively and
allocatively efficient.

Monopoly: The monopoly firm is in stark contrast, since the price is higher than marginal cost; the
monopoly is not allocatively efficient. Nor will the monopoly firm necessarily be productively
efficient, as the output level which has been determined by the MC = MR condition means that the
monopolist might well produce where ACmin is not attained.

And yet... a closer look at some possible benefits of monopolies
Life is seldom so simple as to neatly divide reality into good or bad 2. Monopoly power is no exception as
was shown in Chapter 29 where the monopoly can prove itself superior to the perfectly competitive firm: 1)
economies of scale; 2) natural monopolies; and 3) government run monopolies. Additional possible
benefits of monopolies are increased profits for research and development (R&D), the reduction of negative
externalities and the process of “creative destruction”.
(Type 4 Smaller heading) Profits for R&D (innovation and new products)
There is also the possibility of monopolies having far greater research and development (R&D) capabilities
as a direct result of being able to earn abnormal profits. Ploughing profits back into product enhancements
and innovative new products could increase consumer choice and benefits to society in the longer term.
PCM firms could never have the LR profits available to monopolies, and would thus not be able to fund
R&D to the same extent as monopoly firms.
(Type 4 Smaller heading) Lower negative externalities
Finally there is the distinct possibility that the monopolist outcome of higher prices and lower output
actually benefits society! This would be the case in the production and consumption of goods which are
harmful to society, called negative externalities. For example, the production of certain plastics is highly
harmful to the environment, as numerous carcinogenic toxins (= poisons) are released into the air. A
monopoly firm might well produce less of the good and thereby have less negative impact on society than
would a perfectly competitive market.
As previously shown it is theoretically likely that a profit maximising monopoly firm will set a higher price
and lower output than a perfectly competitive firm. This would normally result in sub-optimal allocative
efficiency (and a dead-weight loss) since the price (AR) would be higher than MC. (See Figure 2.3.31,
‘The PCM firm compared to a monopoly.)
However, let us assume that the monopoly is producing a good for which the negative externalities are
considerable, for example a major tobacco firm wielding monopoly power. The good inflicts costs to
society in increased sick days and falling productivity, increasing health costs etc. This is shown in the left
figure in figure 2.4.6 as the negative externality; MPC  MSC.
2
That is why we have divorce and divorce attorneys.
Fig. 2.4.6 Lower negative externalities due to monopoly
PCM
Monopoly
MPC  MSC; extent of the negative
externality in a monopoly market
MPC  MSC; extent of the negative
externality in the PCM
MSC
P, costs ($)
P($)
MPC
MCmon
Psoc opt
Pmon
Pmon
PPCM
PPCM
Qsoc opt Qmon QPCM
MSB (= MPB)
Q/t
MR
D, AR
Qmon QPCM
Q/t
Output level in the perfectly competitive market creates a negative externality which would not
exist (in this highly theoretical example) in a monopoly market. Therefore, the competitive
market shows suboptimal allocative efficiency while the monopoly is allocatively efficient.
Assuming (as was done in comparing the PCM with a monopoly) that the sum of PCM firms ’ individual
cost curves (MPC in the left diagram) would be the same as the MC curve for the monopoly (MCmon), then
the MPC is the same as the MCmon. This would render a competitive market output of QPCM and a price of
PPCM, and a negative externality (blue double arrow in diagram).
The monopoly plastic company, on the other hand, would base the output/price decision on a different MC
= MR point. The right diagram shows the MC = MR point where the monopolist would set output, and the
higher monopoly price of Pmon and a lower output level of Qmon. Since this results in a lower output and
higher price (Qsoc opt and Popt) for the monopoly, the negative externalities of producing plastic in the
monopoly are actually lower – shown by the orange double arrow. In other words, the monopoly is actually
more allocatively efficient than the competitive market.
I mean, let’s face it; a goodly number of countries’ governments create government run monopolies for
tobacco and alcohol (Sweden, Norway and Finland for alcohol and Greece and Spain for tobacco) for a
good reason – other than tax revenue that is. Operating under monopoly conditions allows governments to
price these ‘bads’ more in keeping with societal costs and benefits. When my home country Sweden
instated a government monopoly on the sales of beer in 1976 alcoholism, alcohol induced psychoses and
intoxication fell by some 40% amongst teenagers. 3
3
See Mats Ramstedt’s article at www.nordicwelfare.org
(Type 4 Smaller heading) Other possible advantages of monopoly
A rather interesing possibility was put forward by noted economist Joseph Schumpeter, who theorised that
there is an on-going process of creative destruction. While it sounds distastefully ‘socio-Darwinist’,
Schumpeter posited that over time sheer monopoly power would force potential entrants to develop
outstandingly new/superior substitute goods in order to compete in some way, rather than the incremental
(= ‘little at a time’) improvements of competitive markets. The new and major new product would
effectively destroy the market for the ‘old’ product while creating a new market. These ‘leaps’ of
innovation and invention effectively terminate markets – creative destruction – in providing superior
substitutes. This is posited as being more beneficial in the long run than competitive markets.
***Pic; buggy at Jose Cuervos. Caption “Where have all the buggies gone?”***
(Type 3 Medium heading) Monopoly versus PCM – a summary
It has been shown that, under the assumption that the PCM supply curve is identical to the monopolist ’s
MC curve, the monopoly will:

enjoy abnormal profits in both short and long runs

be allocatively inefficient (P [AR] > MC), and in all likelihood productively inefficient (Q ≠
ACmin)

produce a lower level of output at a higher price – this leads to a net loss of consumer and supplier
surplus called deadweight loss [not part of syllabus – see ‘Outside the box; Monopolies and
deadweight loss’]
In relaxing the assumption of SPCM = MCmon, there is a mixed bag of both disadvantages and advantages. A
monopoly could:

raise existing entry barriers and indulge in predatory pricing to dissuade entrants

idle along at low productivity levels, resulting in sub-optimality in productivity gains

enjoy economies of scale and natural monopoly, lowering price and increasing output compared to
the PCM

lower the negative externalities of production and consumption of goods

be more innovative that competitive firms, since abnormal profits are available for R&D

Regulating monopoly power
Most countries will have legislation which severely limits both the creation and activities of monopolies
and other restrictive competition practices. As we shall see in the chapter on oligopolies, when the few act
as one there is a monopoly, i.e. when oligopolistic firms act in concert – by perhaps forming a cartel – the
result is basically a monopoly. These anti-trust laws are in place to limit and regulate such collusive (=
cooperative) and harmful behaviour. The anti-trust laws in America are amongst the harshest in the world,
and make it illegal for a firm to have monopoly power at all (!), whereby firms that are judged to be
monopolies can be forcibly broken into parts by order of law. The most famous example perhaps is when
Standard Oil, created by John D. Rockefeller, was forced in 1911 to divest (= sell) itself of holdings in
many other companies – one of which became today’s ExxonMobile. This is also what happened to the
aforementioned ALCOA in 1945 and AT&T in 1983; both were considered to have too large a market
share and were forced to break up into smaller competing firms. As a comparison, the European Union’s
charter does not explicitly forbid monopoly creation per se, but the ‘abuse of the dominant position of a
company which negatively affects the trade between Member States’4.
4
http://europa.eu.int/comm/competition/antitrust/legislation/entente3_en.html
POP QUIZ 2.3.7: MONOPOLY
1.
Explain why a monopoly can earn a supernormal profit even in the LR.
2.
Explain why the profit maximising monopolist will always set output along the elastic portion of the
demand curve. Use a diagram to illustrate your answer.
3.
Explain how/why a monopoly which aims to maximise revenue will have a higher level of output
than when it is profit maximising.
4.
If, at a certain output, the MC is greater than MR, what should a profit maximising monopolist do?
5.
Is it always the case that a monopoly leads to a higher market price and lower output than a perfectly
competitive market or are there exceptions?
6.
Explain how a natural monopoly’s price would differ from that of competitive firms on the same
market.
Summary and revision
1.
Assuming there are no economies of scale available for a monopoly, the profit maximising
monopoly firm will set lower quantity and higher price than the perfectly competitive market firm.
2.
The higher price and lower output level of the monopoly results in a net loss of both consumer and
supplier surplus (e.g. societal surplus). This deadweight loss illustrates that the monopoly is
allocatively sub-optimal.
3.
A monopoly can also engage in so-called predatory pricing where price is set at breakeven (AR =
AC) and potential rivals/entrants are unable to compete at this price.
4.
Monopolies can uphold a monopoly situation by limiting access to factor inputs such as
specialised components and blocking supply/retail chain networks.
5.
It is theoretically possible that monopolies choose to lead a “quiet life” and target acceptable levels
of profit rather than strive for lower costs via increased efficiency.
6.
Assuming there are no economies of scale involved for the monopoly firm in comparison with a
perfectly competitive market, the profit maximising monopoly firm:
a. Will set price above marginal cost (P > MC). The monopoly will be operating under
suboptimal allocative efficiency.
b. Will be productively inefficient since output will not be set where average costs are
minimised (Q ≠ ACmin).
c. Will be able to enjoy long run abnormal profits due to high barriers to entry.
7.
There are several “howevers” in terms of the negative outcomes in monopolies. Advantages over
the perfectly competitive market include:
a. Economies of scale and natural monopolies might well have a lower price and higher
output than would be the case in a perfectly competitive market.
b. Abnormal profits from monopolies can be ploughed (plowed) back into research and
development – R&D – resulting in innovation and new products.
c. Lower negative externalities in production since the monopoly firm has a higher price
and lower output than would be the case on a competitive market.
d. The theoretical possibility of creative destruction – a monopoly might force potential
entrants/competitors to take giant innovative leaps forward to be able to compete with the
monopoly. The significant improvement of the substituting good would destroy the
monopoly.
8.
Most countries will have regulations in place to limit monopolies in general or curtail monopoly
power at the very least. Anti-trust laws commonly limit market share and thus the extent to which
firms are allowed to merge – either voluntarily or via hostile takeovers. Other regulations include
penalties for firms engaging in predatory pricing, collusive behaviour and limiting access to raw
materials for other firms.