Imperfect Competition and Monopolies

Abstract

In this note, we look at what happens when there are only few producers. For simplicity, we start with a market with only one supplier, a monopolist. We analyze the price the monopolist charges and the amount of output he or she produces, how those decisions affect overall welfare, and in what circumstances government intervention can increase overall welfare.

Excerpt

UVA-GEM-0105

Jun. 15, 2011

IMPErfect Competition and Monopolies

The fall of the Berlin Wall in 1989 was seen by many as a victory for democracy and the free market. In the wake of this momentous event, we have learned that introducing a market economy to non-market economies is not easy at all. There is more to a functioning market economy than having demand equal supply through free decision making on the part of consumers and producers. There are many institutions necessary for a market economy to function well. Property rights have to be defined well to determine who owns what, there needs to be the rule of law in order to enforce contracts, there have to be institutions that will look at whether all products are safe and comply with pollution standards, and so on. When listening to the public debate, one almost gets the impression that deciding for more or less government intervention or more or less market freedom is purely an ideological decision. This note helps us think about the market and how it allocates resources in a somewhat more nuanced way.

As is well understood and often argued, in many instances, market transactions give way to the most efficient allocation of resources, and they create the highest welfare (highest producer and consumer surplus). They ensure that only those consumers who care most about a product buy that product and that only the lowest-cost firms get to produce the goods that are sold. What is often forgotten is that this optimal outcome only materializes under certain conditions. For example, there has to be a sufficient number of suppliers, so that no individual firm can set the price (has market power), there has to be full information so that both consumers and producers are fully informed about the quality of the product, and there also cannot be any externalities (i.e., social costs associated with pollution).

In this note, we look at what happens when there are only few producers. For simplicity, we start with a market with only one supplier, a monopolist. We analyze the price the monopolist charges and the amount of output he or she produces, how those decisions affect overall welfare, and in what circumstances government intervention can increase overall welfare.

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Keywords: monopoly