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A monopolist restricts output and charges a price higher than what a firm would be able to charge under perfect competition. This output restriction leads to loss of consumers’ surplus and producers’ surplus. The two losses together constitute welfare cost or social cost of monopoly. By examining these losses, we can determine the net welfare loss to society.
In a competitive market, price equals marginal cost. Monopoly power, on the other hand, implies that price exceeds marginal cost. In Fig. 22.24 DD is the demand curve, SS is the monopolist’s marginal cost curve and the competitive short-run supply curve. MR is the monopolist’s marginal revenue curve. The competitive price is Pc and the quantity supplied and consumed is Qc. The monopoly price is PM and monopolist’s output is QM.
Let us suppose a competitive industry is monopolized. As a result output will fall and price will increase. In this case the loss of consumers’ surplus is equal to the area PMFEPC. But the rectangle PM FDPC becomes part of revenue for the monopolist.
Thus this rectangle represents a transfer from consumers to producers. It is not a loss to society. The net loss of consumer surplus is DEF. Here the rectangle DEC represents the loss in producers’ surplus. So the net welfare loss to society is the sum of triangles EFD and DEG, or the shaded area in Fig. 22.24.
This area represents the excess of the value to society (as reflected in the demand curve) over the cost to society (as reflected in the supply curve) for the units of output lost due to monopolisation of a competitive industry.
Deadweight Loss (Cost) from Monopoly Power:
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Since monopoly power results in higher prices and lower quantities produced, we would expect it to make consumers worse off and the monopoly firm better off. But suppose we value the welfare of consumers the same as that of producers.
The question is: in the aggregate, does monopoly power make consumers and producers better off or worse off?
We can answer this question by comparing the consumer and producer surpluses that result when a competitive industry produces a good with the surpluses that result when a monopolist supplies the entire market.
Here we assume that the competitive market and the monopolist have the same cost curves. Fig 22.25 shows the average and marginal revenue curves and the marginal cost curve for the monopolist. To maximise profit the firm produces at the point where marginal cost equals marginal revenue, so that the price and quantity are PM and QM, respectively.
In a competitive market, price must equal marginal cost. So the competitive price and quantity PC and QC are found at intersection of the average revenue (demand) curve and the marginal cost curve. We may now examine how consumers’ surplus and producers’ surplus change if we move from the competitive price and quantity, PC and QC, to the monopoly price and quantity, PM and QM.
Under monopoly the price is higher and consumers buy less. Due to higher price those consumers who buy the good lose surplus amounting to the rectangle, A. Those consumers who do not buy the good at price PM but who will buy at price PC also lose surplus shown by the rectangle B.
The total loss of consumers’ surplus is therefore A + B. The producer, therefore, gains rectangle A by selling at a higher price but loses rectangle C, the additional profit it would have earned by selling QC – QM at price PC. The total gain in producers’ surplus is therefore A – C.
Subtracting the loss of consumers’ surplus from the gain in producer surplus, we arrive at a net loss of surplus given by B + C. This is the deadweight loss or deadweight cost from monopoly power. Even if the monopolist’s profits were taxed away and redistributed to the consumers of its product, there would be an inefficiency because output would be lower than under conditions of competition. The deadweight loss is the social cost of this inefficiency.
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In practice, the social cost of monopoly power is likely to exceed the deadweight loss triangles B and C in Fig. 22.25. The reason is that the firm may engage in what J.N. Bhagwati calls rent-seeking: spending large amount of money in socially unproductive efforts to acquire, maintain or exercise its monopoly power.
Rent-seeking might involve lobbying activities (and perhaps donations to political parties) to keep the government regulators in operation so that entry by potential competitors is ruled out. Rent-seeking activity could also involve advertising and legal efforts to avoid anti-monopoly scrutiny.
The monopolist might also be creating but not utilizing extra production capacity to convince potential entrants that they cannot sell enough to make entry worthwhile. Normally the economic incentive to incur rent-seeking costs bear a direct relation to the gains from monopoly power (i.e., rectangle 4 minus rectangle C). Therefore the larger the transfer from consumers to the firm (rectangle A) the higher the social cost of monopoly.
Thus in some cases where monopolists spend more and more on the rent-seeking activities than the actual amount of rent they are able to earn in practice, the social cost of monopoly power is likely to exceed the deadweight loss triangles B and C in Fig. 22.25. In fact, the deadweight loss represents additional cost to society.
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According to modern economists the social costs of monopoly are much higher than what theory suggests because we have to take into account not only rent-seeking costs but also rent-defending costs. The monopolist would also spend a lot of resources to defend monopoly profits.
A. C. Harberger has devised a simple method of measuring welfare loss from monopoly. Assume that the long-run average costs are constant for both firm and industry and are represented by the same line LMC = LAC. The perfectly competitive output would be Qc where LMC intersects the demand curve DD.
If a monopolist were substituted, it could maximise profit by producing QM at price P. Monopoly profit would be AECP. The part of this area represented by ABCP, however, is not destroyed welfare but just a transfer of welfare from consumers to the monopolist. The net loss to society as a whole from the monopoly is given by the ‘welfare triangle’ ABE.
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