The Relative Efficiency of Monopoly - Essay Example

The relative efficiency of Monopoly: An essay ‘Monopoly...is a great enemy to good management.’ Adam Smith, (1776), The Wealth of Nations, Book I, Chapter XI. The objective of this essay is to discuss the statement above. To perceive the extent of its truth, it is imperative to initiate an understanding regarding what ‘good management’ refers to here. In spite of the potentially huge spectrum over which the notion can reign, from the perspective of planners whose objective is to ensure the best outcomes for society as a whole, ‘good management’ can be interpreted in essence to be the achievement and sustenance of social efficiencies. Such Interpretation of the notion of ‘good management’ as being equivalent to maximization of ‘efficiency’ implicates the quoted lines as being accusatory about monopoly market structures by pointing out that these forms of markets greatly hinder the generation and sustenance of ‘efficiency’. The essential objective of the present discussion thus is to explore into the relation of ‘efficiency’ with monopoly itself to examine the validity of the statement in question. In pursuit of this objective we shall first explore the concept of ‘efficiency’ to perceive its interpretability as ‘good management’ before comparatively exploring monopoly and perfect competition to asses the relative enmity these market structures exhibit to efficiency and then briefly look at certain oligopoly setups and their relation to efficiency to facilitate a greater comparative understanding of how much hindrance monopoly market forms actually cause to generation and maintenance of efficiency relative to alternative market structures. In economics, achieving efficiency in a very broad and general sense implies attaining a state that ensures the minimum amount of resource wastage. Although efficiency is a concept that encompasses a very broad spectrum of notions, we shall restrict our concern primarily to two types of efficiencies - productive or technological efficiency and allocative efficiency which I believe to be pertinent for perception of the notion of ‘good management’ of society. Productive efficiency is attained if the costs of production are minimized, given the amount of output or if given the costs of production the output is maximized (Varian, 1999). If a firm is able to produce a given level of output at the minimum possible average cost it is said to be productively efficient and this is reflected in the firm operating on its cost curves curve as these show the minimum level of costs at which any given level of output can be produced by the firm1. Again, an industry will be productively efficient if the total output it produces is produced at the minimum cost level possible2. The condition that ensures allocative efficiency3 is the equality between the additional cost of producing an extra unit of output that falls upon the society (Marginal social cost or MSC) and the additional benefit society enjoys due to the extra unit produced (Marginal social benefit or MSB). Therefore allocative efficiency is ensured by satisfaction of the condition: MSC = MSB Now, in the absence of externalities, we can take market demand as a measure of marginal social benefit4. So, we have, P = MSB. Again, the marginal cost curve of the industry reflects the marginal social cost for the market, i.e, MSC = MC. Therefore, allocative efficiency essentially requires P = MC. We now proceed to evaluate monopoly and perfect competition in terms of efficiency. First consider a perfectly competitive long run5 equilibrium scenario. Note in the diagram below, the firm earns zero profits as P = ATC and the equilibrium is characterized by P = MC = ATC = MR = AR. All the firms in the industry are producing at the minimum points of their respective ATC curves and therefore, the industry is productively efficient. Again as the P = MC condition is satisfied, the industry is allocatively efficient as well. Perfect competition therefore ensures firm level and industry level productive efficiency as well as allocative efficiency and thereby stands as the benchmark for the notion of ‘good management’ of society. In the long run equilibrium of a monopoly, the equilibrium price is greater or equal to the corresponding ATC of the equilibrium output level. As the firm produces on its cost curves, firm level productive efficiency is ensured. However there being a solitary firm in the industry, industry level productive efficiency is not achieved since the single firm does not operate at the minimum point of its ATC curve6. Again, producing that level of output which ensures P = MC (the allocative efficiency condition) is suboptimal from the perspective of the monopolist as that shall lead to reduced profits. And thus the monopolist will charge prices greater than the marginal cost of production implying allocative inefficiency (Posner, 1975). Therefore, it appears that a monopoly industry is both productively and allocatively inefficient compared to perfect competition, and thus hindering to ‘good management’ compared to perfect competition. However, monopoly is more efficient than credited. In certain realistic deviations from the standard neo-classical assumptions especially for perfect competition we can have surprising results where we find monopoly to record lower efficiency losses than competition. In some cases perfect competition results in potential inefficiencies and in certain other cases monopolies create opportunities for enhanced efficiencies. In what follows we shall briefly look at some of these special cases of exceptions and explore the conditions that lead to such situations. First consider the presence of externalities in a perfectly competitive market. Resources will be allocated sub optimally and the market shall be thereby inefficient7. If we accept the theory of the second best (Lipsey & Lancaster, 1957) then keeping monopoly may be actually a preferred outcome. The ideal or first best outcome of all markets perfectly being competitive would ensure both productive and allocative efficiency. However, since achievement of perfect competition in all markets is not possible, whether having a few markets as competitive would lead to enhanced efficiency overall is not certain. Thus, the second best outcome for ‘good management’ may be sustaining monopoly power rather than converting a few of them into competitive structures. Economies of scale8 and economies of scope9, which are often the primary causes behind natural monopolies actually imply more efficiency on the part of the monopolizing unit. The firm which has the market power because of economies of scale or scope is actually able to produce more at lesser costs compared to other smaller firms that are out competed as these do not enjoy the scale or scope benefits. So, intervening and breaking up the monopoly to ensure that smaller firms can participate in the market will actually be similar to ensuring the production of lower amounts at higher costs, or lower number of products at higher costs. This essentially implies enhancing the productive inefficiency of the market and thus goes against the principles of ‘good management’ (Gravelle & Rees, 2004). We should also take note of the fact that certain oligopoly structures that lead to collusions and cartel formations are potentially more inefficient than monopolies. Not only are cartels formed to ensure the achievement of monopoly profits which in itself reduces the productive and allocative efficiency compared to a competitive structure, the possibility of sustaining a cartel is also very low due to the prevalent high incentives that exist unilaterally for the individual firms which form the cartels. Breaking down of the cartel shall lead to further efficiency losses. There have been a lot of instances that suggest this outcome in the related literature10. Such empirical proofs actually bolster the theoretical perception of cartels as more harmful to productive as well as allocative efficiency and thereby intrinsically growth and productivity hindering compared to monopolies. Thus we see that a monopoly market structure although is undoubtedly inefficient compared to a perfectly competitive structure, since the latter is unachievable uniformly for all the markets in the world and due to the certain efficiency enhancing features that we observe of monopolies under certain conditions coupled with the potential efficiency loss associated with even competitive structures given certain realistic deviations in the assumptions11 one does tend to ask might there be some kind of situation where we can actually have monopolies leading to efficiency and thereby ‘good management’? Theoretically the answer is yes. If the government through price regulations made the monopolist charge a price equal to its marginal cost, and subsidized the losses, the result would be allocative efficiency as the P = MC condition was being satisfied. Again if the government regulated monopoly was forced to produce the amount which leads to it producing at the minimum of its ATC to ensure industrial productive efficiency, that would be suboptimal for the outfit and thus the government in this case would have to subsidize the firm. An alternative for the government would be to nationalize the monopoly to ensure no efficiency losses occurring out of market motivations12. Although regulation of monopolies is almost universally prescribed to attain maximum efficiency, different economies have different regulatory practices13. Although in the USA the regulation is achieved through regulating and restricting profits, the price is focused upon and regulated in the UK14. In the UK, a monopoly is deemed to exist when one company controls at least 25% of the market15. So, what emerges from this discussion is that monopolies indeed are less efficient when we evaluate them against a perfectly competitive structure under standard assumptions. But accepting the non-viability of such a perfectly competitive structure does open up the question once we note the greater potential efficiency losses associated with collusions and cartels. The fact of the matter remains that although inherently inefficient in terms of allocation and technology, if one considers the natural monopolies that have earned their statuses due to economies of scale and scope and thus efficiency savings, regulating them is always a better option than forcibly ensuring competition as that breeds greater inefficiency by allowing larger number of inefficient performers to go on operating. So it is actually better in terms of good management to keep the monopolies all the while regulating them in these cases. Reference List: H.R. Varian, Intermediate Microeconomics: A modern Approach, 5th ed. W. W. Norton & Company; 5th edition (Jun 2 1999) C. E. Ferguson and J. P. Gould, Microeconomic Theory, 4th ed. Richard D. Irwin: Homewood; 1975 R.A. Posner, The Social Cost of Monopoly and Regulation, Journal of Political Economy 83, 807-827, 1975. W. Baumol, J. Panzar and R. Willig, Contestable Markets and the Theory of Industrial Structure, New York: Harcourt, Brace, Jovanovich, 1982. C. Kolstad .Environmental Economics, Oxford: Oxford University Press, 2000 R.G. Lipsey & Kelvin Lancaster, The General Theory of Second Best, The Review of Economic Studies, Vol. 24, No. 1. (1956 - 1957), pp. 11-32. H., Gravelle, & Rees, R. “Microeconomics”, Pearson Education, 2004 Stephen. N. Broadberry, & Nicholas F.R. Crafts, Britain’s productivity gap in the 1930s: Some neglected factors, Journal of Economic History, 52, 1992, 531-558 (1992) David B. Audretsch, Legalized cartels in West Germany, Antitrust Bulletin, 34, 1989, 579-600 F. Fisher, The Social Costs of Monopoly and Regulation: Posner Reconsidered, Journal of Political Economy 93, 410-416, (1985). J.A. Ordover, Economic Foundations of Competition Policy, in: Comanor, W.S. et al. (eds.), Competition Policy in Europe and North America: Economic Issues and Institutions, (1990) Bibliography: Audretsch, David B. (1989) “Legalized cartels in West Germany”Antitrust Bulletin, 34, 1989, 579-600 Baumol, W., J. Panzar & R. Willig (1982), “Contestable Markets and the Theory of Industrial Structure”, New York: Harcourt, Brace, Jovanovich. Broadberry, Stephen N & Crafts, Nicholas F.R. (1992) “Britain’s productivity gap in the 1930s: Some neglected factors” Journal of Economic History, 52, 1992, 531-558 Fine, B., (1990) “Economies of scale and a featherbedding cartel? A reconsideration of British interwar coal industry” Economic History Review, 43, 1990, 438-449 Fisher, F. (1985), "The Social Costs of Monopoly and Regulation: Posner Reconsidered", Journal of Political Economy 93, 410-416. Hicks, J. R. (1935) “Annual survey of economic theory: The theory of monopoly” Econometrica, 3, 1935, 1-20 Kolstad, C., (2000) “Environmental Economics”. Oxford: Oxford University Press Lipsey R.G. & Kelvin Lancaster, “The General Theory of Second Best”, The Review of Economic Studies, Vol. 24, No. 1. (1956 - 1957), pp. 11-32. Ordover, J.A. (1990), "Economic Foundations of Competition Policy", in: Comanor, W.S. et al. (eds.), Competition Policy in Europe and North America: Economic Issues and Institutions. Posner, R.A. (1975), "The Social Cost of Monopoly and Regulation", Journal of Political Economy 83, 807-827. . Read More