PCM - Inefficiency and Monopolies Lesson

Inefficiency and Monopolies Lesson

Monopolies produce inefficient outcomes in a market. The inefficiency is a result of producing too little of the product while charging a price that is too high. The inefficiency of a monopoly is apparent when compared to perfect competition.

In perfect competition, a firm produces where P = MC (this is the same as saying where demand intersects MC). The sum of consumer and producer surplus is maximized in perfect competition. No deadweight loss exists. However, what is good for society as whole is not necessarily good for a monopoly.

Monopolies choose to produce where MR = MC and P > MC to maximize profit. This means the firm is producing less than the socially desirable quantity. When P > MC, society values this good beyond its cost of production. Society would like to see more of the good produced. Unfortunately, the monopoly will not produce that amount because it will result in lower profit levels.

In this situation, the deadweight loss triangle appears to the left of the socially optimal level of output (where P = MC). Recall from an earlier module, deadweight loss appears to the left of the intersection of demand and supply when too little is produced. It is the difference between P and MC over the range of quantities Qm to Q* in the graph below.

Graph of a Monopoly with DWL highlighted

Society would like to see Q* units produced. However, the monopoly chooses to product Qm units to maximize its profits. The result is the under-allocation of resources to the production of this good.

Monopolies also result in inefficiency because average costs are not minimized at the profit maximizing level of output found at MR = MC.

Price Discrimination

Price discrimination is the practice of charging different customers different prices. It takes a variety of forms. Common examples include airline pricing strategies (business class v. coach class, advanced purchase v. last minute) and age discounts at movie theaters (child pricing and "senior" pricing). To effectively price discriminate, a monopoly must:

Have price making power
Be able to identify and separate groups of consumers
Be able to prevent the transfer of the good from one consumer to another

Price Discrimination Video

View the video below to learn more about the price discriminating monopolist. To make the video full screen, click the double arrows at the bottom right corner of the object.

Price discrimination can reduce the amount of deadweight loss a market incurs due to monopoly power. It can be eliminated entirely if perfect price discrimination is practiced because the monopoly will produce where price equals marginal cost. However, consumer surplus is lessened and even becomes zero in the instance of perfect price discrimination. This is because each consumer is paying exactly what he or she was willing to pay for the unit. There is no difference between willingness to pay and the price paid.

IMAGES CREATED BY GAVS