ChainWhat it assumes · how to break it
Start
A firm holds a dominant share of a market protected by high barriers to entry, so it faces little competitive pressure.
1
As a result, the firm restricts output to where MC = MR and sets a price above marginal cost.
P > MC
P > MC
Assumes: The firm maximises profit.
But: A firm pursuing sales or revenue maximisation produces more, closer to the output where P = MC.
2
This means consumers value the last unit at more than it costs to produce, so the firm is allocatively inefficient and a deadweight loss arises.
allocative inefficiency · deadweight loss
allocative inefficiency · deadweight loss
Assumes: The firm's MC reflects the full cost to society.
But: If production creates external costs, MSC lies above MC and the restricted output may be closer to the social optimum.
3
In addition, output is not at the lowest point of the AC curve, so the firm is productively inefficient.
productive inefficiency
productive inefficiency
Assumes: Several smaller firms could produce at lower average cost.
But: In a natural monopoly the minimum efficient scale is so large that one firm produces at lower average cost than several could.
4
Since managers face little competitive pressure, they have less incentive to control costs, so AC rises above the lowest attainable cost.
X-inefficiency
X-inefficiency
Best link to attack
Assumes: Nothing else forces managers to keep costs down.
Assumes: Nothing else forces managers to keep costs down.
But: Shareholders can replace managers, and a badly run firm becomes a takeover target, so there is pressure to cut costs even without rivals.
End
The monopoly is allocatively and productively inefficient, and may be X-inefficient, compared with a competitive market.
Evaluation chain
- E1However, X-inefficiency arises only if nothing else forces managers to control costs.
- E2If the monopoly is a listed company, then shareholders can replace poor managers and a high-cost firm becomes a takeover target, because a buyer could profit by cutting its costs.
- E3As a result, pressure from the market for corporate control can do part of the job that competition would do.
- E4So monopoly is more likely to be X-inefficient where the firm is shielded from shareholders as well as rivals, for example a state-owned monopoly, and less so where it is a listed company.
Another way to attack it: Supernormal profit gives the firm the funds and security to invest in research and new processes, so it may be dynamically efficient even though it is statically inefficient.
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Questions this answers
- Assess the view that monopolies are always inefficient.
- Explain why a profit-maximising monopolist is allocatively inefficient.
- Discuss whether X-inefficiency is likely to be a problem in a monopoly.
Diagram
Monopoly diagram with AR, MR, MC and AC: mark output where MC = MR, price above MC, and the deadweight loss triangle between AR and MC from the monopoly output to where MC = AR. Show output to the left of minimum AC (productive inefficiency) and draw a second AC curve above the first to show X-inefficiency as AC above the lowest attainable cost.
Reverse and related
More competition → price pushed towards MC and AC and pressure to cut waste, though firms may have less profit to fund research.