Monopoly profit and deadweight loss from monopolies

The existence of monopolies is a fact of economic life. It is occasionally the case that a single, very large, firm can produce an item at a lower per unit cost than several smaller firms could. The resultant monopoly is referred to as a natural monopoly It is also the case that any holder of a patent has a monopoly on that product, and that some individuals have talents that are singular to them. These are also sources of monopoly. If monopolies are so common, and appear so benign, why do countries pass laws making hem unlawful? This apparent contradiction finds its resolution in the notions of monopoly profit and deadweight loss.

Exploration: Why don't monopolists charge even higher prices than they do?

Economic Naturalist 9.1 asks why Intel sells the overwhelming majority of microcomputer processors. As it turns out, Intel has a great deal of monopoly power in this industry. The reason put forth in your text for their position is that the fixed costs of microcomputer processor manufacture are very large. This limits the ability of competitors to start up manufacturing facilities. As a result, there is very little competition in this industry and Intel is the giant of the industry. The overarching point though, is that no matter what the source of monopoly power, whether it stems from patents, knowledge or, as in this case, high fixed costs, it is a fact of economic life. The question we must ask ourselves as individuals and as a society is; what does this monopoly power cost us and what is the gain. Only when we have answered these questions can we begin to develop coherent social and legal policies toward the existence of monopoly.

In this chapter you have explored the various types of monopoly power and have looked at the costs and benefits associated with monopoly. In this set of exercises the objective is that you cement your understanding of the relationship between monopoly and perfect competition and that you develop an intuitive comprehension of these costs and benefits.

1. Using this model, at what output and price combination does profit maximize?
   
   
2. It seems, on the surface, that if Intel produces more than 10,000 chips per month their profit will rise. After all, they are selling more and their fixed costs are already covered so it just seems to make sense that the more you sell the more money you will make. Unfortunately this is not the case. Using the interactive graph, satisfy yourself that if production rises above 10,000 per month, profit will fall.
   
   
3. Well, if raising quantity above 10,000 caused profit to decline, it should follow that lowering production below 10,000 should cause profit to rise. After all, if we produce fewer we can charge more per chip when we sell them and it costs us less to produce them. That must lead to higher profit. Again, unfortunately, while this argument seems to be correct, it is in error. Using the interactive graph, satisfy yourself that lowering production below 10,000 will cause profit to fall.
   
   
4. Click the icon below to open a new window containing a note for the more mathematically inclined
   
   

Exploration: How does monopoly power create deadweight loss in society?

The very existence of monopoly imposes a cost on the society above the cost created in a perfectly competitive economy. A monopolist will charge more and produce less than a perfectly competitive industry facing identical cost and demand relationships. The obvious question then, is why do we allow monopolies to exist in the first place? As it turns out, monopoly power is the price we pay for variety, innovation and high fixed cost methods of production. The Intel example is an illustration of the last of these. Patents are an example of how we reward innovation and invention—we believe that without the economic reward of having a monopoly on your new invention, the drive to invent would be reduced. History seems to bear this out as most invention has come out of self-interest and the drive for wealth in societies which allow inventors protection from others "stealing" their inventions.

The first of the things we "buy" via monopoly power, variety, is not as clear. Recall that one of the conditions of perfect competition is that we have perfect knowledge on the parts of both the consumers and the producers. This means that within a particular market there can be essentially no variation between brand X and brand Y, since everyone knows that they are really the same. The outcome of this type of knowledge would be to reduce the variety that we use to try and separate our product from the competition. As soon as we are successful in differentiating our product from "the pack," we have established some degree of monopoly power. Thus, a perfectly competitive world, while extremely efficient, would also be quite dull, lacking in variety.

However, the fact that we can justify the cost of monopoly power does not make the cost go away. Let's spend some time exploring the relationship between the elasticity of demand for our product (a measure of monopoly power) and the associated cost to society when compared to production under perfectly competitive conditions.

To begin your analysis, click the Reset button in the window above. Now click on the Deadweight Loss button to open that portion of the applet.

5. What is the deadweight loss associated with the existence of this monopoly?
   
   
6. As more firms are added into an industry the demand curve for each individual firm becomes more elastic, since people have the choice of buying the product in more places. Relate the increase in the number of firms in a industry to the deadweight loss resulting from monopoly power.
   
   
7. What is the deadweight loss associated with a perfectly competitive industry?

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Exercise picked up from the 2e Economics textbook.