Other Market Models The Social Cost of Monopoly

Determining the Social Cost of Monopoly

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Lets suppose that you are running a restaurant at the airport. The only one, and you are a monopolist. Should you expect to be unpopular? Will you be surprised that the people in the airport complain about the high prices of your meals? Or are you by surveying the customers, going to be making friends? Heres the question, why are monopolists so unpopular? Perhaps it has something to do with social cost of monopoly. That by increasing their own profits, monopolists are actually imposing costs on society, and thereby shrinking the overall pie of economic value. Thats what we are going to be looking at in this lesson, the social cost of monopoly. But first, let me answer a question that some of you are probably asking. Weve got a demand curve here and a marginal revenue curve in this diagram, but wheres the supply curve? Wheres the supply curve that were used to from our standard supply and demand diagrams? The answer is this: there is no supply curve for a monopolist. The reason is because of the definition of the supply curve. Remember, supply curve tells us the quantity of output that suppliers are willing and able to sell as the price varies in the market. That is, anytime we draw a supply curve, we are assuming passive response on the part of sellers. Were assuming that sellers take the price as given and passively respond by choosing the quantity they want to sell. Now thats a great assumption for a competitive market; but in the case of monopoly, price is not taken as given. Monopolists are not price takers; they are price setters. And because monopolies set prices, rather than take them as given, there is no supply curve for a monopolist. A monopolist has a marginal cost curve like any firm, but because the monopolist gets to choose to produce the output where marginal costs equals marginal revenue, there is no passive response to price. The monopolists sets price, therefore, monopolists have no supply curves. They have marginal revenue curves and marginal cost curves, but the supply decision for a monopolist is more complex than it is for a competitive firm. Therefore, one last time, there is no supply curve for a monopolist. Now suppose this monopolist were forced to behave competitively. Suppose this were a competitive market where maximizing profit meant that you had to equate marginal cost to the price of the product. That is, if firms could freely enter this market and could compete with one another on price and drive the price down, firms would continue to enter and keep producing output until the price fell to the point in which it was equal to marginal cost. That is, the point in this diagram that we would get if firms behaved competitively would be the point where the marginal cost curve intersects the demand curve. Thats the point in which the price would be equal to marginal cost and no further entry would occur. Firms wouldnt want to produce any more of the product. Well, what we would get in that case is price equals marginal cost, so Ill put that in this diagram. Well call this the competitive price; the price in competitive equilibrium and the quantity that the firm would produce or that all firms together would produce in a competitive market would be Qc. So, in this case, price equals marginal cost when the competitive quantity becomes a kind of benchmark for us. Why are we so interested in the price that would occur in a competitive market and the quantity that would be produced? Why is this benchmark interesting? The answer is this: you recall that economists like competitive markets because competitive markets under certain circumstances maximize economic value. Look at this picture, the red curve, the demand curve, is a list of the reservation prices of the different customers in our market. And as long as there are no wealth effects and no externalities, this demand curve represents social benefits. Each point on the demand curve tells us about the benefit that some customer derives from getting a unit of the product. So think about your restaurant for a moment. If you had the demand curve for meals at your restaurant, what you have is a record of the reservation prices of all of the customers that might choose to come into your store and buy a meal. A meal at your restaurant is worth $11.00 to someone, $10.50 to someone else, $9.50 to another customer, $8.50, $7.00 and so forth on down the demand curve. The demand curve summarizes the benefit that customers in the market derive from enjoying your product. The marginal cost curve, if there are no wealth effects and no externalities, the marginal cost curve tells us about the cost to society of providing another meal at your restaurant. The marginal cost of the first meal might be a dollar, the second meal might have a marginal cost of $1.75, and so forth. Just to jog your memory, youll recall that economic value is created anytime we produce and trade another unit of the product, for which the benefit is greater than the cost. Anytime the marginal social benefit is greater than the marginal social cost, we are adding economic value when we increase production. In this case, in the case of your restaurant, the competitive price and competitive quantity tell us about that amount of restaurant service that maximizes economic value. All of the meals from zero up until this point, perhaps 40 meals served a day at your restaurant, give us benefits greater than costs. That is, you can look at the red line and the green line and see that this area at the economic value that can be created, the maximum economic value that could be created at your restaurant.

Other Market Models The Social Cost of Monopoly

Determining the Social Cost of Monopoly

Page 2 of 2

Now heres the question, does that particular choice of price and quantity maximize your profits as a monopoly restaurant owner? And the answer, unfortunately for society, is it does not. If you look here, you find that profit is maximized where marginal revenue equals marginal cost. Weve discussed this before. The monopolist maximizes his or her profits by choosing this particular combination. You maximize your profits at your airport restaurant by restricting the quantity of meals that you serve. Instead of serving 40 restaurant meals a day, you may serve only 30 choosing the monopoly quantity and charging this higher price, the higher price on the demand curve, the price that the market will bear. Now whether you have this price in quantity combination when you restrict output and raise the price, you are imposing a cost on society. Lets see that cost. Look at all of these units that are not being produced and sold. Look at all of these restaurant meals between Qm and Qc that you have decided not to offer. In order to maximize your restaurant profits, you have restricted output below the competitive level and you have raised the price above the competitive level. The reason this is bad for society is as follows. All of these restaurant meals that you do not produce in trade have a higher benefit to society than they cost to produce. There are people in here who are willing to pay more for a restaurant meal than it costs you to produce it, but you are not serving those customers. You are not serving those customers because by raising your price, you are able to charge more to the customers who stick with you than you would earn by serving those additional customers. By restricting your output and charging a higher price, you maximize your profits. You put more money in your pocket. In fact, the money you put in your pocket can be seen in this diagram. By raising the price, from the competitive Pc to the monopoly profit maximizing Pm, you put this additional amount of money into your pocket. All of the customers that you continue to serve, youre making extra revenue off of those customers by charging them a higher price. What you lose on revenue is the extra revenue that you would have earned by serving these customers here between Qm and Qc. By knocking those customers out of the market out of the price range, you no longer get the revenue from them. However, the cost of serving those customers was higher than the cost of serving these other customers, because of the increasing marginal cost. So, the profits that you lose on these customers is small compared to the extra revenue that you earn by charging a higher price to customers who are willing to pay more. Now, heres the problem. The problem, from societys point of view, is all of these people who are not being served, all of these people whose benefits exceed the cost of serving them and they are simply not getting service because the monopolist does not find it privately profitable to serve them. In order to maximize his or her own profits, the monopolist raises the price and charges more to the customers who will pay more, thereby pushing out of the market these marginal customers who are willing to pay enough to cover the cost of their meals but not willing to pay enough to continue to provide profits to the monopolist, to make it worth his or her while to serve them. If I wanted to identify the loss to society from having a monopoly instead of having a competitive market, I would identify the costs of all of these customers here who dont get service. Im shading in an area showing you the loss that occurs from societys point of view when output is restricted from 40 meals to 30 meals a day and the loss is as follows: all of the benefits that the customers would earn, less the cost of serving them. Benefit minus cost is economic value and heres economic value lost when trade is restricted. We call that a deadweight loss. This is the deadweight loss associated with monopoly. When the monopolist restricts trade and raises his or her profits, the monopolist creates a deadweight loss relative to a competitive market. A competitive market would serve more customers; in fact, it would serve all of those customers for whom the benefit is as great as the cost, all of those customers that add economic value for society. But the monopolist finds it privately profitable to restrict trade, charge a higher price, push some customers out of the market, and impose a deadweight loss on society. This is why monopoly is viewed as bad for society. Monopoly is viewed as bad for society because it usually, in fact, almost always entails a restriction of trade relative to competition. And the cost of restricted trade is that some people who benefit more than the cost of providing the good, do not get service. Now, in the next lesson well consider why we allow monopolists to hang around even when they are imposing a deadweight loss on society.