The achievement of productive and allocative efficiency in perfectly competitive markets ensures that the market-determined prices and quantities will maximize social surplus. However, only perfectly competitive markets can meet the nec- essary condition for allocative efficiency—marginal-cost-pricing. As we have demonstrated in previous chapters, price will always exceed marginal cost under monopoly, monopolistic competition, and oligopoly, that is, under imperfect com- petition. The reason allocative efficiency is lost under imperfect competition can be directly attributed to the market power that all imperfectly competitive firms possess. Market power always leads to allocative inefficiency and lost social sur- plus. In this section, we will show you why market power reduces social surplus.
We will also examine monopoly markets and briefly discuss the role of antitrust policy in promoting competition.
Market Power and Allocative Inefficiency
In Chapter 12 you learned that market power is something that competitive firms don’t have—the power to raise product price without losing all sales. Firms with market power, however, do not sell standardized commodities in competition with many other firms. Firms with market power can set prices anywhere they wish along their downward-sloping demand curves. The value, of course, of pos- sessing market power comes from the opportunity to raise price above costs and
market power Ability to raise price without losing all sales;
possessed only by price- setting firms.
earn economic profit, something competitive firms cannot do. As explained in Chapter 12, all imperfect competitors possess some degree of market power. The problem with market power, from society’s point of view, is the loss of allocative efficiency that comes about when imperfectly competitive firms set their prices to maximize profits.
For all firms with market power (not just pure monopolies), the marginal rev- enue curve lies below the firm’s demand curve. For this reason, prices charged by firms with market power always exceed marginal revenue: P > MR. Since profit maximization requires producing at the output level for which MR 5 MC, it follows directly that firms with market power must price above marginal cost (P > MC) to maximize profit. As a consequence, all firms possessing market power fail to achieve allocative efficiency, and thus market power diminishes social surplus.
Any degree of market power reduces social surplus, but a high degree of mar- ket power may do so much damage to social surplus that a government remedy is warranted. When the degree of market power grows high enough, antitrust of- ficials refer to it legally as “monopoly power.” No clear legal threshold has been established by antitrust authorities to determine when “market power” crosses the line to become “monopoly power.” Nevertheless, antitrust agencies aggres- sively seek to prevent firms from acquiring monopoly power and can severely punish firms that acquire or maintain monopoly power in illegal ways. Before we discuss antitrust policy toward monopoly practices, we must present the case against monopoly.
Market Power and Deadweight Loss
The best way to understand the problem caused by market power is to compare an industry under two different equilibrium situations: perfect competition and pure monopoly. We will do this using the Louisiana white shrimp industry as our example. Initially, let’s suppose the industry is perfectly competitive. Figure 16.2 shows market demand and supply conditions in the market for Louisiana white shrimp. Industry demand, D, is downward sloping and, as you know from Chapter 5, D also measures the marginal benefit to shrimp consumers. The long- run competitive industry supply curve for Louisiana shrimp, SLR, is horizontal because the shrimp industry is a constant-cost industry. The flat supply curve in- dicates that long-run marginal and average costs are constant and equal to $100 per 10-pound basket (LMC 5 LAC 5 $100).
The competitive, market-clearing price for 10-pound baskets of shrimp is $100, and the market quantity is 20,000 baskets per month. The competitive equilibrium at point C generates social surplus each month equal to $2 million (5 0.5 3 20,000 3
$200). No greater amount of social surplus can be generated than under perfect competition at point C.
Now suppose that a consortium of investors form a company called Shrimp Depot, and they buy every one of the Louisiana shrimp suppliers, transforming the industry into a pure monopoly. As we will explain shortly, antitrust laws in the United States would certainly prevent such a consolidation, but let’s compare the
monopoly power A poorly defined legal term used in antitrust law to refer to a high degree of market power.
monopol y equilibrium (point M) to the competitive equilibrium (point C) anyway.
Once Shrimp Depot owns all of the productive capacity, the competitive industry supply curve, SLR, now represents the long-run marginal cost and average cost curve for the monopoly shrimp firm. Shrimp Depot possesses market power and finds its profit-maximizing production level by setting marginal revenue (MR) equal to marginal cost (LMC). As you can see in Figure 16.2, Shrimp Depot maxi- mizes profit by producing 10,000 baskets of shrimp per month and charging a monopoly price of $200 per 10-pound basket.
Under monopoly, consumer surplus shrinks by $1.5 million, which is the area fbCM. A portion of this lost consumer surplus—the area of the red-shaded rectan- gle fbeM (5 $1 million)—is transformed into producer surplus or monopoly profit in this example. Shrimp Depot makes $100 (5 P 2 LAC 5 $200 2 $100) profit on each one of the 10,000 baskets of shrimp it sells, which amounts to $1 million of economic profit.
Allocative efficiency is lost under monopoly pricing since monopolists—and any other firm with market power—do not practice marginal-cost-pricing. At point M, the marginal benefit of the 10,000th basket of shrimp is $200, which exceeds its marginal cost of production, just $100. Because price exceeds marginal cost,
F I G U R E 16.2 The Louisiana White Shrimp Market
20,000 10,000
Quantity (10-pound baskets per month)
Price, marginal revenue, and marginal cost (dollars)
MR
C
D = MB SLR = LMC = LAC f M
a
b e
300
200
100
Monopoly profit
DWL
0
resources are underallocated to the shrimp industry, and too little (shrimp) is pro- duced. As a result of this allocative inefficiency, social surplus falls by the amount of the gray-shaded triangle eCM. This lost surplus, which equals $0.5 million (5 0.5 3 10,000 3 $100), is called deadweight loss, because the entire surplus lost on units not produced represents a complete loss of surplus to society. We must stress that deadweight loss, which is attributable to the lack of marginal-cost- pricing, arises not only in monopoly markets but also in markets with any degree of market power.
Promoting Competition through Antitrust Policy
To reduce the cost of market failure caused by market power, most industrialized nations rely on antitrust laws, as they are known in the United States. Canada and the European Union countries refer to their antitrust policies as competition policies.
Because the purposes are quite similar, we will focus our rather brief discussion in this textbook on antitrust policy and enforcement in the United States. Antitrust laws seek to prohibit business practices and actions that reduce or restrain com- petition, based on the fundamental acceptance of competition as a powerful force for achieving large social surpluses and protecting consumers and competitors from firms with substantial market power. We can only take a brief look here at this fascinating area of law and policy. To gain an understanding of the theory and practice of antitrust policy, you must take at least one course in antitrust law.
Monopoly power, or a high degree of market power, can arise primarily in three ways: (1) actual or attempted monopolization, (2) price-fixing cartels, and (3) mergers among horizontal competitors. As you know from our discussion of limit pricing in Chapter 13, firms may engage in behavior designed specifi- cally for the purpose of driving out existing rivals or deterring the entry of new rivals, thereby reducing competition, perhaps to the point of gaining a monopoly position. Firms may be found guilty of actual monopolization only if both of the following conditions are met: (1) the behavior is judged to be undertaken solely for the purpose of creating monopoly power, and (2) the firm successfully achieves a high degree of market power. Businesses can also be guilty of attempted monopo- lization if they engage in conduct intended to create a monopoly and there is a
“dangerous probability of success.”
When businesses are unable to drive out their rivals, or choose not to do so for fear of antitrust penalties, they may instead seek to reduce competition by col- luding to raise prices. Recall that we discussed the nature of collusion and cartels in Chapter 13. Collusive price-setting is absolutely forbidden, and guilty parties incur substantial financial penalties and even jail time. Nonetheless, the enormous profit potential from successful price-fixing continues to attract plenty of practi- tioners. Fortunately, as we explained in Chapter 13, cooperation among rival firms can be very difficult to establish and maintain. Antitrust enforcement agents at the Department of Justice make no secret about their willingness to grant clemency from prosecution to the first cartel member to expose and plead guilty to a price- fixing deal. The prisoners’ dilemma really works!
deadweight loss Social surplus lost on units not produced when price diverges from marginal cost.
Now try Technical Problem 4.
Horizontal merger policy represents the third important area of antitrust doc- trine designed to prevent monopoly power from arising through the process of merger or acquisition of direct rival firms. Horizontal mergers or acquisitions happen when two or more firms that are head-to-head competitors—selling the same product in the same geographic markets—decide to join operations into a single firm. Such mergers can obviously lead to an increase in market power, al- though many horizontal mergers are too small to damage competition. Horizontal mergers can have beneficial effects on social surplus when the merged firm enjoys substantial economies of scale that could not be realized by separate production operations. Of course, consumers only benefit directly from such scale economies if the merged firm passes the cost saving along through reduced prices. Antitrust agencies require firms planning large mergers to notify antitrust authorities of their intentions prior to merging. Antitrust officials typically have 90 days after notification to study a proposed merger and to let the prospective merging firms know whether antitrust agencies intend to challenge the merger or to approve it.
In most cases, businesses will abandon a merger if antitrust agencies plan to chal- lenge the merger in court.
Antitrust policy and enforcement in the United States is the responsibility of the Department of Justice (DOJ) and the Federal Trade Commission (FTC).1 While the language of the law itself is not particularly complex, the legal application can be tremendously complicated. Antitrust litigation can also impose heavy costs on businesses, whether they are defendants or plaintiffs. In 1993, American Airlines reportedly spent $25 million defending itself in a predatory pricing trial that took the jury less than one hour to decide the airline was not guilty.
Before leaving our examination of monopoly, we must consider a special kind of monopoly, called natural monopoly, which would be harmful to break up through the application of antitrust laws. We explain in the following section that natural monopoly arises when one firm can produce the amount of goods desired by society at a lower total cost than having two or more firms share in the produc- tion of industry output. As it turns out, antitrust remedies to break up a natural monopoly would increase total costs and create productive inefficiency. Natural monopoly requires other methods of government regulation to reach an efficient outcome that maximizes social surplus.
Natural Monopoly and Market Failure
Sometimes monopoly can have desirable consequences for society. One such occa- sion arises when a single firm can produce the total consumer demand for a product or service at a lower long-run total cost than if two or more firms produce the total industry output. This situation is called natural monopoly, and it causes market failure. In natural monopoly, productive efficiency requires a single monopoly
natural monopoly One firm can produce the entire industry output at lower total cost than can two or more firms.
1Each of these agencies has its own website designed to inform and educate the public about antitrust law. See, for example, “Promoting Competition, Protecting Consumers: A Plain English Guide to Antitrust Laws” on the FTC website: www.ftc.gov.
producer, which, as you now know, results in allocative inefficiency and dead- weight loss to society. Many public utilities, such as electricity, water, natural gas, local telephone, and cable television, are commonly thought to be natural monop- olies. If two or more local phone companies serve a community, then each phone company must string its own set of telephone wires. By having a single phone company, the community must pay for just one set of telephone lines. The same logic has been applied to other municipal services that require costly distribution infrastructure. One way to avoid the needless duplication of distribution lines is to give one company a monopoly franchise in return for the right to let public regula- tors set the price of service. We will examine some of the complexities of regulat- ing price under natural monopoly shortly. First, we must explain more carefully the conditions on long-run cost that lead to natural monopoly.
Natural monopoly is another way of saying that long-run costs are subadditive at the level of output demanded by consumers. Long-run costs are subadditive at a particular output level __Q if any division of __Q among two or more firms is more costly than letting a monopoly produce all Q __ units. Thus the terms “natural monopoly” and “subadditive costs” mean exactly the same thing. One way for natural monopoly to develop is for long-run average cost to fall continuously, so that economies of scale extend to all output levels. With continuous economies of scale, cost subadditivity and natural monopoly exist at all levels of output. This can happen for public utilities when large quasi-fixed costs of distribution lines (pipelines, telephone lines, fiber-optic cable, electricity power lines, water lines, and sewage lines) are spread over more units of output.2
Figure 16.3 illustrates the nature of cost subadditivity for a water utility in a small town. The water plant and underground distribution lines cost $12 million and are quasi-fixed inputs because they are employed in a fixed amount for any positive level of output (recall the discussion of quasi-fixed inputs in Chapter 8).
Municipal bonds are sold to pay for these inputs, and the debt payment on the bonds is $60,000 per month. The average quasi-fixed cost for the water plant and distribution lines, AQFC, declines continuously, as shown in Figure 16.3. (Note that water consumption is measured in 1,000-gallon units of consumption.) The long-run marginal cost of water is constant and equal to $2.50 per 1,000-gallon unit. Thus LMC is a flat line in Figure 16.3 equal to $2.50 for all output levels.
Long-run average cost, LAC, is the sum of AQFC and LMC. LAC declines continu- ously as the $60,000 quasi-fixed cost is spread over more units of output, and LAC approaches LMC as water consumption gets very large. You can verify that costs are subadditive in this example by comparing the total cost if one firm produces 40,000 units, which is $160,000 (5 $4 3 40,000), to the total cost if two equal-size
subadditive
Costs are subadditive at
__Q if any division of this output among two or more firms is more costly than letting one firm produce it all. Natural monopoly means costs are subadditive.
2Cost subadditivity also arises when long-run average cost is ứ-shaped. However, the range of output over which costs are subadditive for ứ-shaped LAC curves does not extend to all output levels, but rather subadditivity extends continuously from the first unit of output to some output beyond the minimum point on LAC. Thus with ứ-shaped LAC, the range of natural monopoly extends into, but never throughout, the region of diseconomies of scale.
firms produce 20,000 units each to reach 40,000 units, which is $220,000 [5 ($5.50 3 20,000) 1 ($5.50 3 20,000)]. When 40,000 units per month are demanded, monopoly water service saves the community $60,000 per month. With a monopoly water utility, the community pays for just one water plant and distribution network.
With two water utilities, the community must pay for two water plants and two distribution networks. Incurring the quasi-fixed capital cost one time, instead of two or more times, and then spreading the cost over all of market demand creates large cost savings, and a natural monopoly arises.
Regulating Price Under Natural Monopoly
When costs are subadditive at the level of output demanded by society, a monopoly produces the desired output at the lowest-possible total cost to society. A monopolist, however, maximizes profit by pricing above both marginal and average cost. Under monopoly, as we explained previously, consumers not only get too little output, they also can end up paying more than average cost for each unit purchased.
Breaking up a natural monopoly is undesirable because increasing the number of firms in the industry drives up total cost and undermines productive efficiency.
State regulators of public utilities—known as “public utility commissions”
(PUCs) or “public service commissions” (PSCs)—face a challenging task in
Now try Technical Problem 5.
F I G U R E 16.3 Subadditive Costs and Natural Monopoly
10 9 8 7 6 5.50 5 4 3 2.50 2 1.50 1
Price and cost (dollars per 1,000-gallon unit)
0 10,000 20,000 30,000
Quantity (1,000-gallon units per month) 40,000
r s t
50,000 60,000 AQFC LMC LAC
regulating the price that natural monopolies can charge. Regulators would like to force a pricing structure on natural monopolies that creates social economic efficiency. Under natural monopoly, as we will now show you, no one price can establish social economic efficiency.
We can best explain the pricing dilemma facing regulators by returning to the previous example of the water utility. Figure 16.4 reproduces the long-run aver- age and marginal cost curves facing the water utility. Recall that LAC falls contin- uously as the quasi-fixed cost is spread over more units of water output. Clearly, then, regulators wish to maintain a monopoly in water service to fully exploit the cost subadditivity that extends over the entire range of water production, because economies of scale exist at all levels of output in this case. The city’s demand for water and corresponding marginal revenue are shown in Figure 16.4 as D and MR, respectively. While utility regulators do not wish to encourage (or force) competition by increasing the number of water utilities, they also recognize that if the monopoly water utility is unregulated, it will operate at point M on de- mand, which maximizes the water utility’s profit. When water price is $6.50 per 1,000-gallon unit, only 20,000 units are demanded, and the city faces a deadweight loss due to monopoly of $40,000, which is the area of the (unshaded) triangle Mws (5 0.5 3 20,000 3 $4). At point M, the unregulated monopolist’s economic profit is $20,000 per month [5 20,000 3 ($6.50 2 $5.50)].
F I G U R E 16.4 Regulating Price Under Natural Monopoly
10 9 8 7 6.50 6 5.50 5 4.50 4 3 2.50 2 1
Price and cost (dollars per 1,000-gallon unit)
0 10,000 20,000 30,000
Quantity (1,000-gallon units per month)
40,000 50,000 60,000 LMC
D s
t z
M Profit
DWL x MR w
v u
LAC