Behavior and Choice: EC 102

Now that we can determine the market outcome in a monopoly, the next step is interpreting this outcome. How do consumers fare at the monopoly market outcome? What about the seller? We can use welfare analysis to measure consumer surplus, producer surplus, and deadweight loss to approximate the gains and losses to market power.

It’s important to ask this question to understand the consequences of allowing monopolies to exist. Intuitively, one might hypothesize that consumers fare worse in the presence of monopolies than they do in perfectly competitive markets: monopolies produce a lower quantity of output, and mark up their price higher than competitive firms. More broadly, if it can be shown that market power in general is worse for consumers, government regulators may have an incentive to promote competition and break up monopolies in order to support those consumers.

Start with the monopoly. With marginal cost, demand, and marginal revenue, we can find the monopoly outcome, \((P^*_M, q^*_M)\text{.}\) From here, we can measure consumer surplus in the standard way by comparing the consumers’ willingness to pay with the price actually paid. The consumer surplus under a monopoly (let’s call it \(CS_M\)) is the small triangular area above price \(P^*_M\) and below the demand curve. Producer surplus \(PS_M\) extends out to \(q^*_M\text{,}\) and measures the difference between the monopolist’s marginal cost and the price actually charged, \(P^*_M\text{.}\)

Can we compare the monopoly outcome to the perfectly competitive market outcome in one coherent story? As we have seen, these two markets are modeled expressly differently. So, here, let’s use a feature of our monopoly model as a proxy for the perfectly competitive market outcome. In using a proxy, we acknowledge that while this doesn’t perfectly capture what we’d like it to, it’s a reasonable approximation. Since a perfectly competitive equilibrium occurs where quantity demanded equals quantity supplied in a market, the intersection of the demand curve and the marginal cost curve should give us a rough estimate of where quantity demanded and quantity supplied would be equal if this were a perfectly competitive market.

This means we can capture the perfectly competitive market outcome at the intersection of \(MC\) and \(D\text{,}\) where \(P^*_{PC}\) gives the competitive price and \(q^*_{PC}\) gives the number of units exchanged in perfect competition. With these pieces, we can calculate consumer surplus and producer surplus, which here, look like their typical triangular areas. To distinguish from the monopoly case, let’s call these \(CS_{PC}\) and \(PS_{PC}\) respectively.

This likely does not come as a huge surprise. We have discussed how firms with market power do not has strong incentives to increase quantity, as a result of their ability to influence price in the market. As a result, they have stronger incentives to keep quantity low and keep price high. This is precisely what we observe in the market comparison here.

Again, the ultimate conclusions here may not come as a surprise. Since consumers in a monopoly are forced to pay a higher price, and fewer consumers are able to buy, consumer surplus is considerably smaller. Naturally, the seller does better when it is able to exert its market power to keep prices higher, and we see larger producer surplus.

The presence of deadweight loss is important here. If the market were perfectly competitive, all mutually beneficial transactions would take place. However, the presence of market power leads to a reduction in quantity and prevents several mutually beneficial transactions from happening. As a result deadweight loss persists in the market. Relative to markets where firms have no market power, the monopoly outcome is less efficient.