A monopoly is the exclusive possession or control of the supply or trade in a commodity or service. Let’s examine what a monopoly is from a microeconomics perspective using a hypothetical Lemonade market.
Here’s the market for Lemonade in a perfectly competitive equilibrium at a price of Pe and the quantity of Qe. Now, because there are numerous buyers and sellers in this perfectly competitive industry, what do you suppose will happen if any one firm tries to raise its price above Pe?
In a perfectly competitive market, any Lemonade vendor that attempts to raise his price above the equilibrium established by supply and demand would see his quantity demanded quickly fall to zero. Such a vendor would rapidly lose market share as his customers would go to the cheaper priced competition.
The consumer surplus is the triangle C, and the producer surplus is the triangle E. Consumer surplus measures the difference between what consumers would have been willing to pay and what they actually pay. The producer surplus is the difference between the price at which producers would have been willing to supply a good and the price they actually receive.
Now suppose a monopolist corners the Lemonade market and raises the price to Pm. In this case, quantity falls to Qm.
Consumers have to pay more for less quantity, and the rectangle B is transferred to the monopolist. That means consumers are poorer and the monopolist is richer.
What portions of consumer and producer surplus represent the loss of allocative efficiency from monopoly pricing?
The efficiency loss on the consumer side comes from the consumption of lemonade that is forgone under monopoly pricing. The loss of efficiency on the producer’s side comes about by a reduction in output and an undersupply. The loss of consumer surplus is measured by the triangle C while the loss of producer surplus is measured by the triangle E. Together, the triangles C and E measure the loss in allocative efficiency from the monopoly pricing. The loss in allocative efficiency from the monopoly pricing is called the deadweight loss.
A monopoly exists when there is only one seller in the market selling a product for which there are no close substitutes.
In such a case, the monopolist is not a price taker as was our perfectly competitive Lemonade firm. Instead, it is a price maker which means that it exerts considerable control over what the market price will be. The monopolist has this power because it controls quantity supplied in the market.
The market structures of most industries in the US fall somewhere in between a monopoly and pure competition as illustrated below.
From this example, you can see why relatively free, democratic governments do not like monopolies. Monopolies not only transfer income from the many to the few, monopolies also create an efficiency loss in the process.
Through microeconomics and supply and demand graphs, we have proven that a perfectly competitive market yields the most efficient use and allocation of resources, as embodied in productive and allocative efficiency.<< Back to Glossary Index