2. Market Failures and Monopolies

alt Market failure generally describes an outcome where conditions are not met and the marginal social benefit (willingness to pay) is not equal to the marginal social cost so some policy measures need to be justified. However, the unanticipated side effects of public policy (i.e., government failure) can also be one reason for market failure. To illustrate a loss from imperfect competition, let us return to the seedlings market and ask what happens to consumer and producer surplus if there is only one large firm producing all seedlings in the market. This crucial difference is that this individual firm, (a monopolist) faces a downward-sloping demand curve and, consequently can affect the market price of seedlings by changing the output. In other words, it has market power. Given this demand curve, the monopolist chooses (again) the output that maximizes profit. The necessary condition also remains unchanged - where profit is maximized when the marginal cost equals the marginal revenue. But the trick is that for a monopolist, marginal revenue is not equal to the market price. For a monopolist, an increase in output (i.e., from 50,000 to 60,000 seedlings) means a lower price for every (i.e., 60,000 units) - not just last (10,000units) of (seedlings) produced.1 As a result the marginal revenue diminishes more rapidly than demand. In our example (Figure E5), the optimum output for a monopolist is only 600,000 seedlings (quantity QM where MR=MC). The market price (PM) can be found from the demand curve and it is 2,800 € per 10,000 seedlings. The inefficiency of a monopolist can be seen as lower output and higher price (point M) when compared to a perfectly competitive market equilibrium (point P).

Figure E5: Profit maximizing output (no. of seedlings) of a monopolist nursery

The difference between price and marginal cost can be used as a measure for monopoly power. This difference also creates rent for a monopolist. In economies that do not favor competition, rent can actually be the most important source of wealth. This is called rent-seeking behavior. The ultimate source for the monopoly of power is usually a kind of privilege coming from the public sector. In competitive economies firms also seek a monopoly of power, but this usually remains temporary as competition removes (permanent) rents.
Calculation example:Given the (inverse) market demand, P=4000-200QD, where QD is the quantity demanded and P is the price (marginal willingness to pay), a monopolist chooses the output quantity so that marginal cost=marginal revenue. The marginal cost is given by MC=1000+100Q, where Q is the quantity produced and MC is the marginal cost. For a monopolist the total revenue is given by a price (demand) multiplied by the quantity:  (4000-200QD)Q = 4000Q-200Q2. The marginal revenue can be solved by computing the derivative of the total revenue function. Thus, MR=4000-400QD. Now we can solve the optimum quantity by setting MR=MC i.e., 4000-400QD=1000+100QS This can be rewritten as 3000=500Q which results in Q=6. By substituting Q into the demand (not supply) function we can compute that P=2800 (compare to Figure E5).
Area A in Figure E6 shows the welfare loss from a monopoly (i.e., the sum of consumer and producer surpluses "social welfare") that is lost as a result of imperfect competition. It can be illustrated that producers are actually gaining from the monopoly, but the loss in consumer surplus is larger than the gain in producer surplus. Area A is also called the deadweight loss from a monopoly.

Figure E6:  Welfare loss from a monopoly

1. The opportunity for price discrimination is excluded here.

2 Responses to “2. Market Failures and Monopolies”

  1. harleen kaur Says:
    where is figure E5 dude?
  2. jason Says:
    Figure E5 is back. Thanks for letting us know it was missing.

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