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The welfare loss of monopoly

August 15, 2011

The welfare losses of monopoly (or any form of market power) can be shown quite easily by illustrating the consumer and producer surplus on a graph.

Consider the effect of a firm with linear demand and supply curves (the supply curve would really be the marginal cost). The diagram below considers the case where the firm is competing in a perfectly competitive market with an infinite number of identical firms, or has a monopoly on the market.

In the case of perfect competition, then the firm will simply produce at the competitive price, Pc, where the supply and demand curves interact. All firms are identical so will face identical supply curves – if this firm’s supply curve (marginal cost curve) was higher and it was unable to profitably produce at Pc then it would have gone out of business, and if its supply curve was lower and it was able to make profits then other firms would enter the market until all firms were making zero profits. When the firm produces at Pc it will supply quantity Qc.

When it has a monopoly, it instead produces at the point where MR = MC, ie where the marginal revenue curve cuts the supply curve. This is quantity Qm which will sell for price Pm.

Now first consider the consumer and producer surplus in the case of perfect competition.

The yellow area shows consumer surplus and orange area shows producer surplus. I have split the graph into five areas, area a, b, c, d and e. Ignore the purple MR line cutting through areas a, b and d, the areas are just bounded by the blue supply and demand curves and the red dotted lines linking price and quantity combinations.

In the competitive case:

Consumer surplus = a + b + c
Producer surplus = d + e

Now consider the consumer and producer surplus in the case of monopoly.

Again yellow is consumer surplus, orange is producer surplus, and I have added a third colour, grey, to show ‘deadweight loss’ – the area that was surplus to consumers or producers in the competitive case but has now been lost.

In the monopoly case:

Consumer surplus = a
Producer surplus = b + d
Deadweight loss = c + e

The effect of going from perfect competition to monopoly is bad for consumers. Consumer surplus has been reduced by (b + c). Area b has gone from consumers to producers, so this is not an overall welfare loss, just a distributional change from consumers to producers.

However the monopoly is good for producers. Producer surplus has increased by (b – e) and as b is a larger area than e this is a net gain.

Areas c and e are deadweight loss. Consumers have lost c and producers have lost e, this is because there is now less output being produced due to the quantity decreasing from Qc to Qm.

So overall society loses out – there is a net welfare loss when the aggregate welfare of consumers and producers is taken into account, although producers are likely to be happy as they have gained at the expense of consumers. From an economic point of view, here there is an efficiency loss caused by going from perfect competition to monopoly.

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