Download 8. Monopoly deadweight loss

Lecture notes companion 8—Deadweight loss of monopoly
Like a lot of other evils, monopoly imposes a deadweight loss on society, that is, when an industry becomes monopolized, the losers
lose more than the winners gain. If you recall the consumer and producer surplus concepts from ECO231 this is pretty simple to show.
Figure 1
P
In Figure 1, we have the crab industry in perfect competition—lots of crab
fishermen in little crab boats, none big enough to affect market price by
changing his output, all producing the same thing—crab meat. Since we
are considering the industry as a whole, and not an individual firm, we
can depict this with ordinary demand and supply curves.
A
B
PPC
C
S
Consumer surplus, or CS—the consumer’s gain from trade, which is the
area above the price paid and below the demand curve—is shown by
areas A + B + E in the diagram. (You’ll see later why I’ve cut it up into
three pieces.) Likewise, producer surplus, or PS—the producer’s gain
from trade, which is the area below the price received and above the
supply curve—consists of areas C + D + F.
D
Now, let’s say that all these myriad crab firms are consolidated into a
single monopolist, Crabco, Inc. Figure 2 shows the effect of this. Here
we use the MC curve as the industry supply curve. (There are reasons to
E
F
D
QPC
Q
use the ATC curve instead, but clarity of exposition isn’t one
of them.) As we have seen, this results in the monopolist
operating at the MR = MC point, with monopoly price, PM,
greater than the perfectly competitive price, PPC. For output,
it’s reversed; QM is less than QPC.
Now, for the consumer and producer surplus effects of this.
Consumer surplus is the area above the price paid and
below the demand curve—but only up to the quantity
consumed. In monopoly, this shrinks to area A only,
because 1) price rises to PM, and 2) quantity consumed falls
to QM. What happens to areas B and E? Look first at
producer surplus. That’s the area below the price received
and above the supply curve—but only up to the quantity
produced. It’s now equal to areas B + C + D. The increase
in price to PM transferred area B from consumers to
producers—this is the whole point of becoming a
monopoly—but the fall in quantity produced, to QM, causes
area F to be lost. So the monopolist trades area F for the larger area B, and so gains in the process. But what about areas E and F?
They’re the deadweight loss of monopoly. Since industry output falls to Q M, the consumer and producer surpluses of all the crabs
between QM and QPC are lost.
So who gains and who loses? The producer gains, since
Monopoly PS = B + C + D
>
Competitive PS = C + D + F
as long as B > F, which seems likely. But consumers lose, since
Monopoly CS = A
<
Competitive CS = A + B + E
which is obviously true. As a whole, society loses, since consumers’ loss (B + E) Is greater than the producer’s gain (B – F). This is
represented by the deadweight loss E + F.
So this means that government action is always justified when a monopoly arises, right? Well, not necessarily. Market failure can
always be compounded by government failure. Friedman’s Capitalism and Freedom, Chapter 8, gives a cautionary warning against
this. But it is possible that government action can improve the outcome. More later.