Effect of Monopoly Power - Term Paper Example

Monopoly Introduction When there exists only one firm in an industry, then the industry is categorized as “monopoly”. If an industry is composed of only one firm, then the firm behaves in a very unlikely way than it would have done, had it been in a perfectly competitive industry with numerous firms. It is quite unlikely for the monopolist producer to take market price as given. A monopolist firm has certain market power with the help of which the firm can influence the market price. Exercising its power on market price, a monopolistic firm chooses its output level and price of the product in such a way that its profit is maximized. (Perloff, 2009) It is, however, not the case that, the monopolist is able to choose the level of output and price in a complete independent way. In fact, for any given level of price, a monopolist is able to sell only that much amount of output which the market of the product will be able to put up with. If a monopolist chooses a very high level of price, then it would be able to sell only a very little amount of output. Hence, choice of price and output of a monopolist is always constrained by consumers’ demand behavior. However, with increase in the level of monopoly power, the monopolist is able to exercise more control on price. (Perloff, 2009; Varian, 2000) Although firms always want to have some monopoly power, but economists or policy makers of any nation are always worried about monopolistic structure of any market. One of the major things of concern about a monopoly is that unlike perfect competition monopoly causes significant losses in economic efficiency. Every nation wants to have highest possible level of efficiency in its production sector. But presence of monopoly places some obstacles in achieving higher level of economic efficiency. Not only has that with increase in the degree of monopoly power level of economic efficiency also decreased significantly. (Perloff, 2009; Varian, 2000) However, apart of loss of economic efficiency, there exists another very important issue of concern with regards to monopolistic structure of an industry in any nation. This issue is the issue of distribution. If existing firms in any industry possesses monopoly power then, it will inversely affect income distribution structure. Sometimes, economists or policy makers use to place much importance on the negative effect of monopoly power on economic efficient, rather than the undesirable effects of monopoly power of firms on distribution of income. But from the perspective of welfare of a country, it can be found quite frequently that welfare of a country affected more badly by unequal distribution of income than achievement of lower economic efficiency. So over time economists all over the world are getting more concerned about the distributional issue of monopoly power rather than the issue of economic efficiency. Hence it would be quite interesting to find out to how what extents economic efficiency and distribution are suffered by the existence of monopoly power and whether it is right to be more concerned about the distribution issue of monopoly power rather than the issue of economic efficiency. However, moving into a detail analysis of effect of monopoly power on economic efficiency and distributional aspects, it would be better to provide a brief analysis of the output and price determination of a monopolist for the betterment of the understanding of the issue under consideration. (Kriesler, 1987) Determination of price and output in Monopoly Like any firm in any industry, a monopolist is also a profit maximizer. To understand the process of profit maximizing of a monopoly firm, the profit maximization exercise of a monopolist can be presented algebraically as well as diagrammatically. Suppose, p(q) stands for market the inverse demand curve faced by the monopoly firm and c(q) represents the costs incurred by the monopolist. Now, revenue of the firm can be denoted as r(q) = p(q)q. hence, the profit maximizing problem of the monopolist can be presented as follows: Max r(q) – c(q). q The optimality condition of the profit maximization can be explained as follows: At the optimum level of marginal revenue of the product must be equal to the marginal costs of the product. A logical explanation of this condition is that if marginal revenues are less than marginal costs, then it would pay the firm to decrease its output level as the savings in cost would be more than make up for the loss in revenue, whereas if marginal revenues are higher than marginal costs then, it would prompt the firm to increase its output. The only point where the firm will be left with no incentive to change its output will be the point at which marginal revenues will be equal to marginal costs. In algebraic term, the condition of profit maximization can be given as follows: MR = MC ……………………………………………….(1) Now, MR can be expressed in terms of elasticity of demand as follows: MR(q) = p(q)[ 1 + {1/ e(q)}] ……………………………………(2), Where, e(q) stands for the elasticity of demand. Now substituting equation (2) in equation (1), the following equation can be obtained: p(q)[ 1 + {1/ e(q)}] = MC ………………………………………. (3) Since, price elasticity of demand is used to be negative then the equation (3), can be rewritten as follows: p(q)[ 1 - {1/ ׀e(q)׀}] = MC ………………………………………. (4) (Varian, 2000) A monopolist normally operates at that portion of the demand curve, where the absolute value of elasticity is greater than 1. It will never choose to operate at some point of the demand curve where absolute value of the elasticity is less than 1. this is because, at some point where absolute value of elasticity is less than 1, reducing output results in increase in revenues and since reducing output cause decline in costs, hence profit definitely increases. As a result it is not possible to reach a point where profit will be maximized on the inelastic portion of the demand curve. (Varian, 2000; Lerner, 1934) From, the equation (4), it will be possible, to find out how markup pricing takes place in monopoly industry. Mark-up pricing can be defined as the process through which a monopolist charges a price higher than the MC. To show, how mark-up pricing takes place, it is just necessary to rearrange the equation (4). Rearranging the equation the following can be obtained: p(y) = MC (y*) / [ 1 - {1/ ׀e(q)׀}] …………………………………… (5), where y* is the optimum level of output produces by the monopolist. Equation (5) reflects the fact that, the level of mark-up depends on the elasticity of the demand curve. Lower is the magnitude of the elasticity of the demand curve, the higher would be the level of mark up. Higher is the level of mark up set by a monopolist firm, higher would be the level of monopoly power that the firm possesses. Now it would be possible to show the determination of price and output of a monopoly firm in terms of a diagram. Figure 1 diagrammatically presents equilibrium level of price and output of a monopoly firm. Price AC ∏ = Profit MC p* MR AR= Demand curve q* Output Figure 1 (Varian, 2000) The figure 1 represents the case where the firm is facing a linear demand curve. The average Revenue Curve (AR) itself represents the demand curve facing the firm. MR curve lies below the AR unlike in case of perfect competition. MC and AC curves represent marginal and average cost curves of the monopolistic firm, respectively. p* and q* stand for the optimum level of price and output, respectively, at which profit of the firm is maximized. The shaded region in the diagram represents the profit obtained by the producer. Now it would be possible to measure the inefficiency that results from the profit maximizing behavior of a monopoly. Monopoly power and economic efficiency The most common argument against monopoly power of a firm in the market is that monopolistic producers have a tendency to earn abnormal profits at the expense of economic efficiency. In the presence of monopoly, economic efficiency gets declined which in turn affects the consumers’ as well as the society’s welfare. This issue of loss in economic efficiency under monopoly can be illustrated in the following way: Production under monopoly leads to three kinds of losses in efficiency: allocative efficiency, productive efficiency and X efficiency. It is quite clear from figure 1 that a monopoly firm sets its price at a level higher than marginal as well as average costs of production. This kind of price setting system leads to a loss in allocative efficiency a makes the market mechanism to fail as a monopolist becomes able to earn a profit higher than the normal profit. It simply implies that a monopolist extracts a price from consumers which is above the costs of inputs employed in the production process of the output. Along with these, in a monopoly market consumers’ needs and wants are not adequately satisfied as the output is under consumed. In a perfectly competitive market consumers get to consume higher level of output at lower price. Consumers are better off in perfectly competitive market than in monopoly set up. (Varian, 2000; McConnell et al. 2004) Profit maximizing behavior of a monopolistic firm also results in productive inefficiency as at the equilibrium point, the producer is not operating at the lowest point on the average cost curve. In perfectly competitive market, a firm operates at the lowest point on the average cost curve in long run. It simply implies that at optimum level, average costs incurred by a monopolist is quite higher. Now, the high level of average cost in the presence of inefficiencies in the production process implies that the monopolistic firm is not making efficient use of available scare resources. Under such conditions, government interventions are required to limit the scale of monopoly power. (McConnell et al. 2004; Blinder et al. 2001) Apart from allocate and production inefficiency, operation of a monopoly firm also results in X-inefficiency. The term of X-inefficiency was first introduced by Harvey Libenstein. X inefficiency results from the absence of real competition in a monopoly market set up. When real competition is not adequately present in a market, then producers have less incentive to make sufficient amount of investment in the generation of new innovative ideas or to take into account the aspect of consumer welfare. It is generally argued that even if a monopolist get to earn sufficient amount of advantages from economies of scale than a firm in a perfectly competitive industry, the monopolist possesses little amount of incentive to control costs of production and in such case the term X-inefficiency simply implies that saving of real cost will not take place under monopoly market structure. (McConnell et al. 2004; Blinder et al. 2001) It has become quite clear that operation of a firm in a monopoly market results in economic inefficiency. But it is now necessary to measure the extent of loss in economic efficiency. The loss in the level of economic efficiency is not same for all types of monopolistic producer. Higher is the level of the monopoly power, the greater would be amount of losses in economic efficiency. To measure the extent of loss in efficiency, the concept of dead weight loss is used. This concept can be illustrated with the help of the following diagram. p p Monopoly Price Competitive Price Market supply p** A Market supply p* B Monopoly demand Market demand q* q q** q* q (McConnell et al. 2004; Blinder et al. 2001) The above two figures show how the level of price and output change from perfect competition to monopoly and how this process leads to a loss of welfare. In the above figures it is found that as a firm moves from perfectly competitive market towards monopoly, price increases to p** while out gets reduced to q**. At the increased level of price and declined level of output, economic welfare gets reduced. When price rise to p** from p*, it results in a fall in consumer’s surplus. Some of this decline in consumer surplus then gets transferred to producer in the form of producer surplus in terms of higher profit. But, the rest of the reduced consumer surplus is not reassigned to producer or any other economic agent. As a result the remaining part of the loss in consumers’ surplus becomes a pure loss in welfare. This loss is known to as dead-weight loss. In the figure 2.2 above, the triangle ABC represents the dead-weight loss. From the figures above, it becomes quite evident that higher is the level of mark up, that is higher is the level of monopoly power, the greater would be the amount of dead weight loss. Economists of any country are very much concerned about the loss in economic efficiency caused by the operations of monopolists. But the interesting thing is that although it apparently seems that higher level of monopoly power would cause higher level of loss in economic efficiency, an appropriate market arrangement can reduce the extent of efficiency loss. The main reason behind loss in economic efficiency in a monopoly market is that monopolists restrict output by charging higher price. But the scenario will be completely different if monopolist charges different prices for different level of output. This kind of scenario is known to as price discrimination. Price discrimination can be of three types: First Degree Price discrimination: In this case, the monopolist sells different units of output at different prices. Not only that, the monopolist can also sell different units of output to different persons. Under this situation, pareto efficient allocation of resources can be achieved as in case of perfect competition. Second Degree Price Discrimination: in this case, different units of output are sold at different prices, but every person who purchases the same amount of good has to pay same price. In this case also loss in economic efficiency is reduced significantly. Third Degree Price discrimination: under this case, outputs are sold to different people at different prices. But the interesting thing here is that each unit of output is sold to a certain individual at the same price. This kind of market arrangement also reduces the extent of dead weight loss. Hence, although policy makers frequently worry about monopolistic market structure of any product with regard to loss in economic efficiency, and hence, try to impose various kinds of restrictions on the firm which on many occasion worsen the situation, the issue can be effectively dealt with proper market arrangement. More than the issue of economic efficiency, the issue of distribution of income seems to be far more crucial as the distribution issue has the potential to directly affect total production of a nation. (Varian, 2000; Nicholson, 1998) Monopoly power and distribution of income Although the basic argument against monopoly is related to the issue of efficiency loss, a far more important issue that needs significant attention is inverse effect of the operations of monopolistic markets on income distribution of a country. Although compared to the issue of loss in economic efficiency, the mal-distribution of income issue gets relatively lower level of attention, the issue had attracted the attention of economists long ago. It has been widely found that divergence of the market from perfectly competitive structure results in transfer of income from wage earners to the profit earners. With increase in the degree of monopoly, the ratio of total profit to total earnings also becomes quite high. Kalecki has developed a theory in which he proposed a close relationship between the pattern of income distribution and effective demand. In his theory he also proposed that the distribution pattern of income is determined by the level of monopoly power, or in other words, by the level of degree of monopoly. Now, how degree of monopoly affect income distribution which in turn affect total output and employment can be illustrated in the following way: For the convenience of the analysis suppose that every worker is productive and each of the worker’s productivity is given and constant. Now gross profit can be defined as the difference between the value of total production and the value of total prime costs. Now total prime costs can be assumed of made up of wages only, for the sake of simplicity. Now, it is generally seen that the pattern pf distribution of income is determined by the firms’ ability in fixing the level of prices in relation to the total level of prime costs incurred during the process of production. (Kriesler, 1987) Now if wage rate and productivity of workers are given, then under such condition increase in the level of prices of the firms automatically causes an increase in the ratio of price to the costs incurred. Consequently, unit profit margin gets enhanced. Now with increased level of price and unchanged level of wage rate, workers would be able to buy a smaller share of output of the industry, while the capitalists would now be able to purchase a higher share of the value added of the industry. To be put in other words, increase in the level of price, or the degree of monopoly, results in a change in income distribution in favor of profits earned by the capitalists, but against wages. (Kriesler, 1987) With affecting the income distribution, change in the level of monopoly power seriously affect output and level of employment. When monopolist charges higher prices, income distribution changes in favor of the profit earners. Now, it is known that marginal propensity to consume is low for profit earners than for wage earners. As a result the profits earners will spend higher proportion of their increased income on capital accumulation than on consumption of goods. On the other hand, decrease in the share of wage earners in total income, causes level of consumption to fall. Since marginal propensity to consume is higher for wage earners than for profit earners, fall in the demand of goods and services due fall in the share of wage earners’ income in total income is higher than the increase in demand for goods and services due to increase in the share of profit earners’ income in total income. The net result is therefore a decline in total effective demand of goods and services. With increase in effective demand, production shrinks which in turn cause a decline in the level of employment (Kriesler, 1987) Conclusion Reviewing the effect of monopoly power on economic efficiency and on income distribution, one thing has become evident that there is nothing wrong in the saying that monopoly power is more of an issue of distribution rather than of economic efficiency. Although monopolists operation results in loss of economic efficiency, the extent of the loss can be reduced by making appropriate market adjustments. But the distribution issue is quite hard to deal with as increase in degree of monopoly automatically causes a change in income distribution in favor of profit earners which in turn reduces output and employment. Hence, government interventions are required to control monopoly power to have favorable effect on income distribution rather than on economic efficiency as economic efficiency can be restored even in completely monopolistic structure though price discrimination. References 1. Blinder, A.S; Baumol, W. J and Gale, C. L 2001. Microeconomics: Principles and Policy. NY: ThomsoN 2. Kriesler, P. 1987. Kalecki's microanalysis: the development of Kalecki's analysis of pricing and distribution. Massachusetts: CUP 3. Lerner, A.P. 1934. "The Concept of Monopoly and the Measurement of Monopoly Power" The Review of Economic Studies, 1 (3):157-175. 4. McConnell, C. R.,. Brue, S. L. and Campbell R. R. 2004. Microeconomics: principles, problems, and policies. NY: McGraw-Hill Professional. 5. Nicholson, W. 1998. Microeconomic theory: basic principles and extensions. NY: Dryden Press. 6. Perloff, J. M. 2009. Microeconomics. NJ: Pearson. 7. Varian, H.R. 2000. 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