Marginal analysis shows why monopoly markets are allocatively inefficient

Marginal analysis assumes that rational decisions are made when the additional benefits resulting from a decision exceed the marginal cost of that decision. In this context, firms use marginal revenue and marginal cost to determine their output and pricing decisions.

Monopoly markets (including natural monopolies) are ones in with many buyers and but only one seller, with no suitable substitutes, so the monopoly firm is a price maker. Natural monopolies are firms that gain their market power because their minimum average cost of production occurs near the total potential demand in the market. If new firms attempt to enter the market they expand production lowering their average cost so are able lower the price and thereby undercut any competition.

Allocative inefficiency occurs when the sum of consumer and producers surpluses are not maximised. The amount of lost consumer and producer surplus is called the deadweight loss.

Key concept indicators

• Illustrates on graphs for perfectly competitive and monopoly firms:
  • the cost and revenues curves needed to determine its profit maximizing output (in both the short and long run)
    • for perfectly competitive firms these are the D=AR=MR, MC and AC curves
    • for a monopoly firm these are D=AR, MR, MC, (and possibly the AC) curves
  • the profit maximising price and output position
    • for perfectly competitive firms this occurs where P (=MR) = MC
    • for a monopoly firm this occurs where MR = MC
  • the impact of changes, in monopoly and perfectly competitive markets, on the short and long run price and output decisions, of the monopoly and perfectly competitive firms, including changes in:
    • demand which will shift the average and marginal revenue curves
    • variable cost  which will shift the marginal cost curve (and so the average cost curve)
    • fixed costs which will shift the average cost curve.

Note: Some of these illustrations will involve showing complex concepts. For example, identifying the long run price and output decisions of a perfectly competitive firm resulting from a change in market demand.

• Illustrates on market graphs for:
  • perfectly competitive firms
    • the market output which occurs where P(=AR) = MC
      that is, the Q where S = D so total surpluses are maximized so it is allocatively efficient
  • a monopoly firm
    • the market output which occurs where MR = MC
      that is, the Q where profits are maximised but MR < AR so a deadweight loss occurs and monopoly markets are allocatively inefficient
    • the impact of government interventions that could be used to improve the efficiency of monopoly markets. Examples of government policies that could be used include:
      • regulations splitting up the monopoly, nationalising the monopoly or that order the firm to produce at the socially efficient output level
      • setting the price where P_monop = AC or subsidising the monopoly so P_monop = MC
      • any other intervention that increases efficiency in a monopoly market.

Note: Some of these illustrations will involve showing complex concepts. For example, correctly identifying (with labels or shading) the rectangle of subsidy required for a natural monopoly to operate where P=MC.

• Provides detailed explanations ¹ of:
  • pricing and output decisions for perfectly competitive and/or monopolist firms using marginal analysis
  • the impact of a change in a market on the short and/or long run pricing and/or output decisions of a firm using marginal analysis
  • the efficiency of perfectly competitive and monopoly market structures
  • how a government policy(s) improve the efficiency of a monopoly market.

Note: Detailed explanations relating to the efficiency of different market structures should be supported by evidence from the relevant firm or market graph.

• Compares and contrasts:
  • the impact of a change in a market, using marginal analysis, on:
    • the short run and long run pricing and/or output decisions of a perfectly competitive firm
    • the short run and long run pricing and/or output decisions of a monopoly firm
    • perfectly competitive and monopoly firms, short and/or long run pricing and/or output decisions
    • the relative efficiency of perfectly competitive and monopoly markets
    • the effectiveness of different government policies that could be used to improve the efficiency of a monopoly market.

Note: Evidence from the relevant perfectly competitive or monopoly firm and/or market graph(s) will need to be integrated into any compare and contrast explanation related to the efficiency of different market structures.

For example, when explaining in detail why a perfectly competitive market is allocatively efficient but a monopoly market is inefficient, integrating would require reference to deadweight loss triangle present on the monopoly market graph (indicating that it is allocatively  inefficient) and that commenting that no deadweight loss triangle appears on the perfectly competitive market graph (indicating that is allocatively efficient). 

1 – detailed explanations to economic questions typically have three parts. For example, What is the answer, Why is this the answer, How do you know?

Example

Use marginal analysis to explain the output decision a monopoly firm would make if variable costs increased.

Answer

The monopolist would reduce their output as increasing variable costs decreases a monopolists marginal cost (from MC to MC¹) meaning MC¹ is greater than MR at its current output level (Q_start). To avoid making marginal losses the monopolist will reduce output (to Q_LR) which occurs where MC1 = MR returning the firm to its profit maximising level of output.

Note: Hypothetical evidence has been added to show how an economic model could be used to support a detailed explanation.

Last updated May 10, 2013

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