Monopolies and economic welfare loss

Pure monopolies, and those firms with monopoly power, will attempt to maximise profits - unless another objective takes precedence.

In the standard monopoly diagram below, the profit maximising monopolist will operate at output ‘Q’ and price ‘P’. While this is clearly to the benefit of shareholders (or other legal owners) it is likely to result in the loss of welfare to society.

We can compare the position of the profit maximising monopolist with the equivalent welfare if the industry is supplied under perfect competition.

If the industry is perfectly competitive, rather than a monopoly, equilibrium would be at point ‘K’, with welfare at a maximum.

‘Welfare’ is the sum of the industry’s consumer and producer surplus.

TMonopoly and welfare loss

But if monopolised, demand becomes the average revenue (AR) curve, and supply becomes the marginal cost (MC) curve.

The price rises to P (rather than P1 for the competitive industry). Here, consumer surplus shrinks while producer surplus grows.

There is a loss of consumer surplus and a net gain in producer surplus - but it is important to note that there is an overall (or ‘net’) loss of welfare of area A K L.

Monopoly and welfare loss
Video on monopolies and welfare loss

There are several possible interventions that can be employed to reduce the welfare loss, including:

  1. Opening up the market to competition
  2. Price capping
  3. Imposing regulations, such as stetting quality standards
  4. De-regulating if the monopoly is state controlled
  5. Nationalisation, where the state takes over ownership and control

In the UK, energy companies have been price capped, and although not pure monopolies they have a large degree of monopoly power. The current cap is set at £1,138 per year (as of February, 2021).

For a regulator, deciding the level of the cap is difficult and setting it too high can force the firm into making losses. In more general terms, regulators can suffer from what is called ‘regulatory capture’, where those entrusted to regulate may, perhaps unwittingly, takes the side of those it should be regulating.

Perfect competition

More on perfect competition.

Perfect competition

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Game theory

How does game theory explain oligopoly?

Game theory