The Wrong Market Structure!

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The Wrong Market Structure!

As we said earlier, the only truly efficient market structure is that of perfect competition. Unfortunately, this is a fairly unrealistic theoretical model. Very few markets in the world are perfectly competitive, although many are very competitive. Theoretically, market failure occurs if a market does not have a perfectly competitive market structure.

Monopoly is the antithesis of perfect competition. It is the least competitive market structure, with only one firm in the industry. The following diagram sums up why the market fails when there is a lack of competition in a given industry. You may need to look at the topics of 'Costs and revenues' and 'Market structure' if you do not remember where these curves come from.

The Wrong Market Structure!

The diagram shows the situation faced by a monopolist. The monopolist maximises profit where marginal cost equals marginal revenue (MC = MR). This gives a price of Pm and quantity Qm. Its profit is represented by the shaded box, which is the difference between total revenue (OPmEQm) and total cost (OFDQm). Remember that, because this is the only firm in the industry, this diagram represents the whole industry. So if this industry was perfectly competitive, the equilibrium would occur at point B, where the demand and supply curves cross (AR = MC). This gives a price of Ppc and a quantity of Qpc.

Notice that the lack of competition in monopoly means that the price is higher and quantity supplied/demanded is lower than under perfectly competitive circumstances. More importantly, the monopolist is not producing at a level of output that is either allocatively efficient (which occurs at point B, where price = MC) or productively efficient (which occurs at point A, the minimum point of the AC curve). Under monopoly, the market fails in that it is not efficient using any measure.

You may be asking yourself, "how come the perfectly competitive equilibrium is allocatively efficient (point B) but not productively efficient (point C) given that perfectly competitive firms are meant to be fully efficient?" Remember, this diagram represents the whole industry. Each of the numerous firms in perfect competition will be both allocatively and productively efficient in the long run (see the topic on 'Market structure' for detail).

We can apply this analysis to a simpler supply and demand diagram which might be easier to understand.

The Wrong Market Structure!

Again, the perfectly competitive equilibrium occurs where supply equals demand (point C), price Ppc and quantity Qpc. As we saw in the first diagram, the monopolist raises the price (Pm) resulting in reduced quantity (Qm) so as to maximise his profits. This diagram shows the loss to society as a result of monopoly in terms of consumer surplus and producer surplus.

Consumer surplus falls from ACPpc to ABPm as a result of the price rise. Some of this loss is transferred into producer surplus, or monopoly profit (PmBFPpc). But the triangle BCF is a dead-weight loss. Triangle CDF is also lost. This represents profit, or producer surplus, that would have been earned at the higher level of output, Qpc, but is no longer available because the monopolist has restricted the level of output. So the overall loss to society is the larger shaded triangle BCD.

The diagrams above show how monopoly, as a market structure, is a form of market failure. The monopolist is neither allocatively nor productively efficient. There are a couple of points to note. First, it should be remembered that monopolists can usually take advantage of huge economies of scale. This can cause large reductions in their average costs that may offset the damaging effects of profit maximisation. Secondly, it should be noted that all market structures that are, in some way, imperfect will not be totally efficient. The monopolist takes the biscuit, obviously, but oligopolists face relatively little competition, and may even collude, causing inefficiency.

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