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Externalities with monopoly

October 16, 2011

When a firm produces a negative externality (like pollution) then the social marginal cost will be greater than the private marginal cost so a competitive market will produce an output higher than the socially optimal level of output.

Negative externality and competitive market

But what would happen if the firm concerned was a monopoly?

In the example here, the output produced by the monopoly firm is now lower than the socially optimal level of output.

We can do a welfare analysis to see the welfare effects of producing at the monopoly output compared to the socially optimal level of output:

At the monopoly price-quantity combination:
Consumer surplus = A + B
Private producer surplus = C + D + F + G
Externality cost = 0
Welfare = consumer surplus + private producer surplus – externality cost = A + B + C + D + F + G

At the socially optimal price-quantity combination:
Consumer surplus = A + B + C + D + E
Private producer surplus = F + G + H
Externality cost = 0
Welfare = consumer surplus + private producer surplus – externality cost = A + B + C + D + E + F + G + H

The difference in welfare between the competitive output and the socially optimal output is E + H, this is the deadweight loss of the externality in this monopoly market.

However this is not a general rule that can be said to be true for all monopolies. Look at this case as an example, where the firm faces a more elastic demand curve and the marginal harm of the externality is greater (so there is a greater difference between PMC and SMC):

This time the monopoly is producing an output that is greater than the socially efficient amount, although not by as much as it would be if there was a competitive market. Here the welfare losses caused by the negative externality are less in a monopoly environment than they would be in a competitive environment. This is a point worth remembering when it comes to things like energy markets. People naturally assume that competitive markets are better than ones with market power, but if there is a negative externality of pollution that comes with consuming energy, then the economic welfare effects may be less bad for society if there is a monopoly or oligopoly provider producing a lower amount at higher price for consumers (and enjoying high profits) than if there was a competitive market, prices were forced down for consumers, and an excessive amount of energy was consumed.

When there is a negative externality:
– A competitive market will produce too much output relative to the social optimum.
– A monopoly market may produce too much or too little output relative to the social optimum, depending on two offsetting effects:
Elasticity of demand: high elasticity means low Lerner index and low mark-up, closer to the competitive market so more likely to be producing too much output; inelastic demand means high Lerner index, high mark-up and more likely to be producing too little output.
Marginal harm of the externality: high marginal harm means a big difference between SMC and PMC, so monopoly is more likely to be producing too much output, low marginal harm means a SMC is more in line with PMC, so monopoly is more likely to be producing too little output.

When there is a positive externality:
– A competitive market will produce too little output relative to the social optimum.
– A monopoly market will also produce too little output relative to the social optimum. In this case a monopoly will be worse for society than a competitive market. The elasticity of demand and the marginal benefit of the externality will influence the degree to which society loses out by having a monopoly.

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