Monopolies And Market Failure
A pure monopoly company is one which is a single supplier for a good or service within their market, however these are very rare and therefore monopoly companies within the UK are usually classed as companies that have 25% or more market share. A monopoly company has three very distinctive characteristics, there is only one dominant firm in the market, there are very high barriers to entry to prevent new firms from entering and finally they sell differentiated products. For example, Google is a monopoly within the search engine market because they have 67% of market power. Market failure occurs when scarce resources are not allocated efficiently or when market forces fail to create social welfare gain. There are two types, complete market failure, when there are ‘missing markets’ for products and partial market failure, when the market provides the goods/ services but at the wrong price or for the wrong quantity.
There are many reasons why markets fail, however market failure caused by monopolies is very common and is caused because of their dominance within the market which allows them to do what they want, for example set extremely high prices because no other competitors can achieve their economies of scale and survive, this causes consumer welfare to be damaged. According to neoclassical economists a monopoly creates a rigid demand curve and restricts supply creating a deadweight loss. The diagram below illustrates this rigid demand curve and the effects this has on the price offered for a product or service The diagram above illustrates how monopolies are able to manipulate the market in anyway they want, point (P1, Q1) would be the economically efficient point to produce at however because the monopoly is the single supplier for the good this means they can provide the good/ service at equilibrium (P2, Q2) which is a higher price and lower quantity, not meeting consumer demand and meaning that some consumers are unable to afford the good. They do this because they have the power and ability to profit maximise and therefore seize this and produce at P2. Market failure occurs with monopoly power because the monopoly is considered both allocatively and productively inefficient. Allocative efficiency occurs where MC=P and productive efficiency occurs when MC=ATC and monopoly companies produce at neither of these points, instead they operate where MC=MR. The following diagram illustrates how a monopoly maximises profit at point MR=MC.
A monopoly would supply at P1, Q1 as this is where MC=MR. The fact that monopolies are so powerful due to their high prices and ability to restrict competition due to barriers to entry means that they are undesirable because they are capable of preventing new innovative ideas entering or surviving within the market. Their highly funded research and development departments can restrict any success from new entrants and they are also able to dominate advertising which means that consumers are only seeing their products and services limiting exposure of new competitors which may even have created a more developed product or service. Furthermore, this links to the fact that monopolies are therefore x-inefficient as they have a lower incentive to cut costs because of a lack of competition. Having no incentive to cut costs also means that the monopoly may feel no need to limit waste creation for example, pollution including noise and visual implications. The creation of waste and pollution exemplifies how monopolies are a form of market failure because an alternate market structure would most likely strive to limit this from happening to not damage the environment and limit the welfare loss associated with this. Deadweight loss is the loss in producer and consumer surplus due to an inefficient level of production resulting from market failure and in this case, monopoly market failure illustrated below.
The deadweight welfare loss is shown by the blue triangle and represents the potential gains that could have gone to either the consumer or producer but instead did not go to either. The initial welfare was the entire triangle including the yellow area, purple area and blue area, however because this firm is a monopoly and therefore produces at the point where price is Pm and quantity is Qm the blue area is the welfare that is lost from doing so. The most prominent welfare loss associated with monopolies is that of deadweight welfare loss because of the monopolies ability to manipulate the market and not provide gains to neither themselves or the consumers, but more so the consumers because the monopoly will make supernormal profits and the loss incurred is unlikely to damage profits enough to do things differently as this may also threaten their ability to remain the market leaders.
There are four different ways in which a monopoly may form and cause market failure, the first being if a firm has exclusive ownership of a scarce resource because they created it and are the only ones that know how, for example Microsoft. Governments may also grant a firm monopoly status because it is more efficient to have one supplier of a good rather than allow competition, the Royal Mail was an example of this within the UK up until 2006. In addition, producers may also patent their designs or copyright ideas and other product aspects not allowing anyone to copy their ideas limiting market entry. Finally, monopoly could be created as a result of a merger between two firms with high market share in order to further their benefits of economies of scale, however there is close regulation of these to keep markets fair. Because of the fact there are different ways for monopolies to be formed this means that they don’t always create market failure and provide a welfare loss to society, however when they do government intervention attempts to rectify any problems that may arise from monopolies or stop them from forming at all.
There are several ways that the government intervene to restrict monopolistic competition and many reasons why they do so, for example, to prevent excess pricing, keep a high quality of service, prevent the monopoly from exploiting their power to become a monopsony as well and to promote healthy competition. In order to address the market failure associated with necessities powered through monopolies such as water, electricity and gas the government introduced pricing caps to prevent new monopoly firms from overpricing the services and leaving consumers with no choice but to accept the unfair price. This was done by using a formula known as RPI-X or RPI +/- K for the water industry. X is the amount by which they have to cut prices in real terms and K is the amount of investment that the water firm needs to implement if they were to raise prices. As with all government intervention techniques there are advantages and disadvantages to RPI- X regulation. To begin, a firm is given the incentive to cut costs to allow for more profits which can make them more efficient, it allows for competition to enter the market as it prevents the abuse of monopoly power and charging excessively high prices and finally, the regulator can change the regulation to adapt to the industry and any potential savings in efficiency. However, it can be costly and difficult to decide on what level X should be at, taking up valuable government time, there is also a risk of regulatory capture where the regulators are taken advantage of if not enough effort goes into withholding the regulation.
Moreover, if a firm is able to still maximise their profits by becoming more efficient they may be penalised by regulators for ‘doing too well’ and be subject to unfair regulation, for example if X is increased for them compared to other competitors. Furthermore, another way the government intervenes to reduce market failure through monopoly power is by investigating any abuse of said power. Within the UK the Office of Fair Trading is able to investigate monopolies to prevent any unfair practices such as; Collusions between firms where they both agree to set higher prices and limit further market entrants. Predatory pricing, meaning when firms deliberately reduce their prices, possibly to below a profitable amount in order to force potential rival firms out of the market before they have got a foothold. Finally, and possibly the most used method of government intervention is through ‘merger policy’ whereby the government investigates mergers which can create a monopoly power, if they believe that a certain merger will result in a monopoly it is automatically transferred to the Competition Commision who then have the power to allow or block it from occurring. To conclude, I think that government intervention is necessary to help reduce market failure through monopoly power because even though this level of power is in fact dynamically efficient it still creates inefficiencies and causes market failure which has negative effects for consumers creating goods/ services that in some cases become limited to only a number of people.
