Explain why monopoly is considered to be a less economically efficient market form than competition. Show...

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.

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

Expert Solution

(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.

Rahul Sunny answered 2 years ago

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