Question

1. Explain why monopoly is considered to be a less economically efficient market form than competition. Show by a diagram the impact on social welfare of the conversion of a competitive market to a monopoly market.

2. Explain how elasticity of demand for a monopolized product is related to the Lerner index of monopoly power.

Answer 1

(a)

Efficiency is maximized when the price charged equals marginal cost (MC) of the firm. In perfect competition, firms maximize profit by equating price with MC. So this is market-efficient. But a monopolist maximizes profit by equating marginal revenue (MR) with MC, and corresponding price is higher than MR, so the price is higher than MC. Accordingly, the monopolist produces a less-than-optimal output and higher-than-optimal price, which causes inefficiency.

In following graph, competitive (efficient) outcome is at point A where demand (D) intersects MC with efficient price Pc and output Qc. Monopoly outcome is at point B where MR intersects MC with higher price Pm and output Qm. This causes inefficiency loss equal to area ABC.

(b)

Lerner Index = (P - MC) / P = - 1 / Elasticity of demand (Ed)

In monopoly, P > MC and the firm has market power. So, the higher the Lerner Index and monopoly power, the higher the value of (- 1 / Ed), the lower the value of (- Ed) and therefore, the less elastic the demand.