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It’s good to be a monopolist, but it’s not so good to be a monopolist’s customer. A monopolist, by reducing output and raising prices, benefits at the expense of consumers. But buyers and sellers always have conflicting interests. Is the conflict of interest under monopoly any different than it is under perfect competition?

The answer is yes, because monopoly is a source of inefficiency: the losses to consumers from monopoly behavior are larger than the gains to the monopolist. Because monopoly leads to net losses for the economy, governments often try either to prevent the emergence of monopolies or to limit their effects. In this section, we will see why monopoly leads to inefficiency and examine the policies governments adopt in an attempt to prevent this inefficiency.

By restricting 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 loss in consumer surplus. And what we learn is that the loss in consumer surplus is larger than the monopolist’s gain. Monopoly causes a net loss for society.

To see why, let’s return to the case where the marginal cost curve is horizontal, as shown in the two panels of Figure 8-8. Here the marginal cost curve is MC, the demand curve is D, and, in panel (b), the marginal revenue curve is MR.

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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 profit and 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—equal to the area of the green rectangle, PS_M. Note that this profit is surplus captured from consumers as consumer surplus 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). In Chapter 5, we analyzed how taxes generated deadweight loss to society. Here we show that monopoly creates a deadweight loss to society equal to the area of the yellow triangle, DL. 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 P_M.

If you recall our discussion of the deadweight loss from taxes you will notice that the deadweight loss from monopoly looks quite similar. Indeed, by driving a wedge between price and marginal cost, monopoly acts much like a tax on consumers and produces the same kind of inefficiency.

So monopoly hurts the welfare of society as a whole and is a source of market failure. Is there anything government policy can do about it?

Policy toward monopoly depends crucially on whether or not the industry in question is a natural monopoly, one in which increasing returns to scale ensure that a bigger producer has lower average total cost. If the industry is not a natural monopoly, the best policy is to prevent monopoly from arising or break it up if it already exists. Let’s focus on that case first, then turn to the more difficult problem of dealing with natural monopoly.

The De Beers monopoly on diamonds didn’t have to happen. Diamond production is not a natural monopoly: the industry’s costs would be no higher if it consisted of a number of independent, competing producers (as is the case, for example, in gold production).

So if the South African government had been worried about how a monopoly would have affected consumers, it could have blocked Cecil Rhodes in his drive to dominate the industry or broken up his monopoly after the fact. Today, governments often try to prevent monopolies from forming and break up existing ones.

De Beers is a rather unique case. For complicated historical reasons, it was allowed to remain a monopoly. But over the last century, most similar monopolies have been broken up. The most celebrated example in the United States is Standard Oil, founded by John D. Rockefeller in 1870. By 1878 Standard Oil controlled almost all U.S. oil refining; but in 1911 a court order broke the company into a number of smaller units, including the companies that later became Exxon and Mobil (and more recently merged to become ExxonMobil).

The government policies used to prevent or eliminate monopolies are known as antitrust policies, which we will discuss in the next chapter.

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Breaking up a monopoly that isn’t natural is clearly a good idea: the gains to consumers outweigh the loss to the producer. But it’s not so clear whether a natural monopoly, one in which a large producer has lower average total costs than small producers, should be broken up, because this would raise average total cost. For example, a town government that tried to prevent a single company from dominating local gas supply—which, as we’ve discussed, is almost surely a natural monopoly—would raise the cost of providing gas to its residents.

Yet even in the case of a natural monopoly, a profit-maximizing monopolist acts in a way that causes inefficiency—it charges consumers a price that is higher than marginal cost and, by doing so, prevents some potentially beneficial transactions. Also, it can seem unfair that a firm that has managed to establish a monopoly position earns a large profit at the expense of consumers.

What can public policy do about this? There are two common answers.

1. Public Ownership In many countries, the preferred answer to the problem of natural monopoly has been public ownership. Instead of allowing a private monopolist to control an industry, the government establishes a public agency to provide the good and protect consumers’ interests.

Some examples of public ownership in the United States include passenger rail service, which is provided by the public company Amtrak; regular mail delivery, which is provided by the U.S. Postal Service; and in some cities, including Los Angeles, there are publicly owned electric power companies.

The advantage of public ownership, in principle, is that a publicly owned natural monopoly can set prices based on the criterion of efficiency rather than profit maximization. In a perfectly competitive industry, profit-maximizing behavior is efficient, because producers produce the quantity at which price is equal to marginal cost; that is why there is no economic argument for public ownership of, say, wheat farms.

Experience suggests, however, that public ownership as a solution to the problem of natural monopoly often works badly in practice. One reason is that publicly owned firms are often less eager than private companies to keep costs down or offer high-quality products. Another is that publicly owned companies all too often end up serving political interests—providing contracts or jobs to people with the right connections.

2. Regulation In the United States, the more common answer has been to leave the industry in private hands but subject it to regulation. In particular, most local utilities like electricity and natural gas, are covered by price regulation that limits the prices they can charge.

We saw in Chapter 4 that imposing a price ceiling on a competitive industry is a recipe for shortages, black markets, and other nasty side effects. Doesn’t imposing a limit on the price that, say, a local gas company can charge have the same effects?

Not necessarily: a price ceiling on a monopolist need not create a shortage—in the absence of a price ceiling, a monopolist would charge a price that is higher than its marginal cost of production. So even if forced to charge a lower price—as long as that price is above MC and the monopolist at least breaks even on total output—the monopolist still has an incentive to produce the quantity demanded at that price.

The upcoming Economics in Action describes the case of broadband, a natural monopoly that has been alternately regulated and deregulated as politicians change their minds about the appropriate policy.

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Monopsony It is possible to have a market in which there is only one buyer and many sellers, so that the buyer can use its power to capture surplus from the sellers. That market is called a monopsony.

Like a monopolist, a monopsonist will distort the competitive market outcome in order to capture more of the surplus, except that the monopsonist will do this through quantity purchased and price paid for goods rather than through quantity sold and price charged for goods.

Monopsony, although it does exist, is rarer than monopoly. The classic example is a single employer in a small town—say, the local factory—that is purchasing labor services from workers. Recall that a monopolist reduces output in order to get a higher price and increase its profits. A monopsonist does much the same thing. But with a twist: it reduces the number of employees hired to pay a lower wage and increase its profits.

Just as a monopolist creates a deadweight loss by producing too little of the output, a monopsonist creates a deadweight loss by hiring too few workers (and thereby producing too little output as well).

Monopsony seems to occur most frequently in markets in which workers have a specialized skill, and there is only one employer who hires based on that skill. For example, physicians have often complained that in some parts of the country where most patients are insured by one or two insurance companies, the companies act as monopsonists in setting the reimbursement rates they pay for medical procedures.

What to Do About Monopoly? Managing monopoly (and monopsony) can be tricky because trade-offs are often present. In the case of drug monopolies, how can the prices consumers pay for existing drugs be reduced if the profits from those sales fund research and development of new drugs?

In the case of a regulated natural monopoly like power generation, how can power producers invest in cost-saving technology and new production capacity if they receive regulated returns and are therefore insulated from market forces? And on the flip side, when the electricity industry is deregulated, how can regulators assure that consumers are not gouged through market manipulation?

Economists and policy makers have struggled with these questions for decades because the best answer is often found through trial and error—as we’ve seen through the various attempts at electricity deregulation. Perhaps, in dealing with monopolies, the best answer is for economists and policy makers to remain vigilant and admit that sometimes midcourse policy corrections are needed.