By holding output below the level at which marginal cost is equal to the market price, a monopolist increases its profit but hurts consumers. To assess whether this is a net benefit or loss to society, we must compare the monopolist’s gain in profit to the consumers’ loss. What we learn is that the consumers’ loss is larger than the monopolist’s gain. Monopoly causes a net loss for society.

To see why, let’s return to the case in which the marginal cost curve is horizontal, as shown in the two panels of Figure 62.1 on the next page. Here the marginal cost curve is MC, the demand curve is D, and, in panel (b), the marginal revenue curve is MR.

Panel (a) shows what happens if this industry is perfectly competitive. Equilibrium output is Q_C; the price of the good, P_C, is equal to marginal cost, and marginal cost is also equal to average total cost because there is no fixed cost and marginal cost is constant. Each firm is earning exactly its average total cost per unit of output, so there is no producer surplus in this equilibrium. The consumer surplus generated by the market is equal to the area of the blue-shaded triangle CS_C shown in panel (a). Since there is no producer surplus when the industry is perfectly competitive, CS_C also represents the total surplus.

Panel (b) shows the results for the same market, but this time assuming that the industry is a monopoly. The monopolist produces the level of output, Q_M, at which marginal cost is equal to marginal revenue, and it charges the price, P_M. The industry now earns profit—which is also the producer surplus in this case—equal to the area of the green rectangle, PS_M. Note that this profit is part of what was consumer surplus in the perfectly competitive market, and consumer surplus with the monopoly shrinks to the area of the blue triangle, CS_M.

By comparing panels (a) and (b), we see that in addition to the redistribution of surplus from consumers to the monopolist, another important change has occurred: the sum of profit and consumer surplus—total surplus—is smaller under monopoly than under perfect competition. That is, the sum of CS_M and PS_M in panel (b) is less than the area CS_C in panel (a). Previously, we analyzed how taxes could cause deadweight loss for society. Here we show that a monopoly creates deadweight loss equal to the area of the yellow triangle, DWL. So monopoly produces a net loss for society.

This net loss arises because some mutually beneficial transactions do not occur. There are people for whom an additional unit of the good is worth more than the marginal cost of producing it but who don’t consume it because they are not willing to pay the monopoly price, P_M. Indeed, by driving a wedge between price and marginal cost, a monopoly acts much like a tax on consumers and produces the same kind of inefficiency.

When an excise tax is imposed on a good produced by a monopoly, even less of the good is sold, and the deadweight loss grows. However, a lump-sum tax—one that does not depend on the quantity sold—does not contribute to the deadweight loss unless it is so high that it causes the monopoly to close down. The reason is that a lump-sum tax does not affect the marginal cost or the marginal revenue, so the monopoly goes on producing the same profit-maximizing quantity.

We have seen that monopoly power detracts from the welfare of society as a whole and is a source of market failure. Is there anything government policy can do about it?