Negative consequences of Monopoly

But there are still some complications we have not taken account of. So far we have been assuming that the monopoly has the same cost conditions that a competitive industry would have. The complications arise when the monopoly and a competitive industry cannot have the same cost conditions.

This could happen for two reasons.

The monopoly, lacking the spur of competition, wastes resources so that its cost curves are above those of a competitive industry. The term for this is "X-Inefficiency."

This is a deviation from the neoclassical assumption of absolute rationality, but perhaps a very important realistic deviation. A good deal of observational evidence suggests that different firms can have quite different costs, in what seem to be the same circumstances. Competition, driving prices down, will tend to eliminate this problem – by eliminating the high-cost firms. In the absence of any competition at all, we would expect costs to be higher than they would be in a competitive industry. There is some evidence that this is true.

There are economies of scale, so the monopoly, operating on a larger scale, can achieve lower costs. This is the case of natural monopoly.

5. "Natural" Monopoly

Here is a picture-example of "natural" monopoly. The example assumes that there is one indivisible cost, but that once it is paid, the firm can produce an unlimited amount at a constant marginal cost. Thus, the Long Run Marginal Cost is horizontal, but the Long run Average Cost is downward- sloping.

The dilemma is that output Q₁, where MC=price, is still the efficient output. But at that output, the monopoly cannot cover its total costs. On the other hand, a profit-maximizing monopoly will produce much less, at Q₃, which covers costs but it inefficient.

In different countries and at different times, governments have dealt with this problem in three primary ways:

Government Ownership

Government ownership could, in principle, solve the problem, since the government could operate the monopoly efficiently, charging a price equal to marginal cost, and cover the losses out of tax revenues.

In practice, however, government monopolies usually seem to have been operated as "cash cows" for the government, and that's not a solution to the problem of high monopoly prices! It has been quite common around the world (for example) for public telephone monopolies to raise the price of telephone service to pay the deficit of the postal system. Poor telephone service at a high price is the predictable result.

Regulation

The most common response has been regulation. In this system, a private monopoly is recognized and protected as such, on the condition that it keep its price down below the profit-maximizing level. The monopoly would be allowed to earn a "fair rate of return." Over the years, this was more and more interpreted as meaning that the monopoly would operate at Q₂, where the price just covers average cost. This is less efficient than Q₁, but better than Q₃. However, there are some other complications that led economists and regulators to question this interpretation by the 1960's. In recent years, the trend has been away from regulation.