Pure Monopoly: Economic Effects

In examining the economics of pure competition, it was shown that to each firm, demand is completely elastic. Therefore each firm can sell all that it wants at the market price, so each individual firm will maximize its own profits by increasing production until marginal cost equals price. However, because of competition, inefficient firms are driven out and more efficient firms are attracted to the industry, so they produce their product for the minimum average total cost. Under pure competition:

Price = Marginal Cost = Minimum Average Total Cost (ATC)

Because product is produced for the minimum ATC possible, a competitive market achieves productive efficiency. Additionally, because the product is sold at the lowest possible price, competition also achieves allocative efficiency, since the lower price not only allows the greatest number of consumers to enjoy the product, but it also maximizes consumer surplus.

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However, as demonstrated in the previous article, a monopolist does not set the price equal to its minimum average total cost, but rather when marginal revenue equals marginal cost.

Marginal Revenue (MR) = Marginal Cost (MC)

Therefore, a monopoly does not achieve productive efficiency. Moreover, the monopolist chooses a price on the demand curve that corresponds to the point where marginal revenue equals marginal cost, which is a higher price than when the price is equal to the minimum average total cost. Therefore, the monopoly does not achieve allocative efficiency either, which means that many people will not enjoy the product because of its higher price and those who do buy it will enjoy less consumer surplus. A monopoly's higher price is like a private tax that exhibits the same deadweight loss that most taxes exhibit.

The Disadvantage of a Monopoly to Society

Because consumers of a monopoly product pay a higher price than they would have under a competitive market, there is a transfer of income from the consumers to the owners of the monopoly. In general, owners of businesses, including stockholders, tend to be wealthier than the buyers of a monopoly product, so this causes a transfer of income from poorer people to wealthier people, creating a greater inequity than would otherwise be the case.

The other great disadvantage of a monopoly is that it often does not seek to improve its products more than it has to, since there is no incentive to do so. In fact, there could be incentive not to do so. A good example of this is Microsoft. Because it has a monopoly in the office software suite and for operating systems, it makes only small improvements to each version of Microsoft Office and Windows so that people will continue to buy upgrades. Another good example of how a monopoly can reduce innovation is again considering Microsoft with its Internet Explorer browser. During the 1990s, Microsoft suppressed Netscape by offering its browser as part of the operating system, and it argued in court that they do not charge for it because it was part of the operating system. Although many people hated Internet Explorer 6 because it had many deficiencies, and didn't use industry standards for HTML, CSS, and JavaScript, Microsoft, nonetheless, would not spend a lot of money improving the product because they were giving it away for free, so improving the browser would not yield additional revenue. However, when other companies started developing browsers that were much better than Internet Explorer, such as Firefox, Google's Chrome, Opera, and Apple's Safari, Microsoft started spending a lot more money to develop Internet Explorer because it did not want to lose its dominant position as the main tool that people use to browse the Internet.

Some monopolies do maintain research and development because the barriers to entry into the industry may be short-lived, which is true in the case of patents, for instance, which is why drug companies continually spend billions of dollars every year developing new drugs.

Monopolies will also often use the legal system to thwart would-be competitors, especially with regard to patents. Even when the monopolist does not have a strong legal position, the exorbitant cost of defending against a patent suit in most countries can effectively suppress competition.

Cost Inefficiencies of a Monopoly

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Competitive firms must generally produce their product for the lowest average total cost; otherwise, they are driven out of business. However, a monopoly has no such concerns, because it has high barriers to entry to protect its position. Therefore, monopolists often do not operate anywhere on the minimum average total cost curve, but usually operate at some point above, which is generally referred to as X-inefficiency. Although X-inefficiency reduces monopolist profits, it persists, nonetheless, because managers become comfortable in their jobs, they are unwilling to take risks, and they have no incentive to develop new products. Often, jobs are given to fawning employees rather than to competent people.

Monopolies often spend a lot of money to maintain the monopoly, which increases average total cost of producing a product. Nonetheless, monopolies are so profitable that they are willing to spend the money to maintain the monopoly even at the expense of society. For instance, drug companies often use legal maneuvers to extend the patent protection of their drugs, or, like Microsoft, they engage in court battles and public relations to maintain their monopoly for as long as possible. These maneuvers are frequently referred to as rent-seeking behavior, because they maintain the economic rent received by the monopoly, the excess amount earned solely because of the monopoly.

Regulating Monopolies

When a monopoly arises, how should the government handle it? It depends. If it is a natural monopoly, where a single supplier can provide the product or service at a reduced cost, then the government can regulate the prices that it can charge, which is the case for natural gas and electricity. If the company achieved its monopoly by anticompetitive means, then the government can force it to stop various business practices that are being used to maintain its monopoly. Microsoft, for instance, is prohibited from doing various things, although the company was allowed to continue charging high prices for its Windows operating systems and for its Microsoft Office software.

Eventually, monopolists lose their dominance because of changes in technology and because of the complacency of its managers. Again, Microsoft is a great example. Even though it earns huge profits, the company has been largely stagnant over the past decade, unable to compete in new areas, such as providing software for mobile devices. It also doesn't have much of a presence in tablets or the software used to run tablets, even though Microsoft was one of the first companies to spend a lot of money in developing tablet computers. Currently, it is spending a lot of money on search as well, but it has not taken much market share from Google.