Monopoly Versus Perfect Competition

When Cecil Rhodes consolidated many independent diamond producers into De Beers, he converted a perfectly competitive industry into a monopoly. We can now use our analysis to see the effects of such a consolidation.

Let’s look again at Figure 61.3 and ask how this same market would work if, instead of being a monopoly, the industry were perfectly competitive. We will continue to assume that there is no fixed cost and that marginal cost is constant, so average total cost and marginal cost are equal.

If the diamond industry consists of many perfectly competitive firms, each of those producers takes the market price as given. That is, each producer acts as if its marginal revenue is equal to the market price. So each firm within the industry uses the price-taking firm’s optimal output rule:

(61-2) P = MC at the perfectly competitive firm’s profit-maximizing quantity of output

In Figure 61.3, this would correspond to producing at C, where the price per diamond, PC, is $200, equal to the marginal cost of production. So the profit-maximizing output of an industry under perfect competition, QC , is 16 diamonds.

Recall that the perfectly competitive outcome of P = MC is allocatively efficient: by producing up to point C, the firm provides every unit for which consumers are willing to pay at least the marginal cost. But does the perfectly competitive industry earn any profit at C? No: the price of $200 is equal to the average total cost per diamond. So there is no economic profit for this industry when it produces at the perfectly competitive output level.

We’ve already seen that once the industry is consolidated into a monopoly, the result is very different. The monopolist’s marginal revenue is influenced by the price effect, so that marginal revenue is less than the price. That is,

(61-3) P > MR = MC at the monopolist’s profit-maximizing quantity of output

So the monopolist does not meet the P = MC condition for allocative efficiency. As we’ve already seen, the monopolist produces less than the competitive industry—8 diamonds rather than 16. The price under monopoly is $600, compared with only $200 under perfect competition. The monopolist earns a positive profit, but the competitive industry does not.

We can see that compared with a competitive industry, a monopolist does the following:

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Monopoly Behavior and the Price Elasticity of Demand

A monopolist faces marginal revenue that is lower than the market price. But how much lower? The answer depends on the price elasticity of demand.

Remember that the price elasticity of demand determines how total revenue from sales changes when the price changes. If the price elasticity is greater than 1 (demand is elastic), a fall in the price increases total revenue because the rise in the quantity demanded outweighs the lower price of each unit sold. If the price elasticity is less than 1 (demand is inelastic), a lower price reduces total revenue.

When a monopolist increases output by one unit, it must reduce the market price in order to sell that unit. If the price elasticity of demand is less than 1, this will actually reduce revenue—that is, marginal revenue will be negative. The monopolist can increase revenue by producing more only if the price elasticity of demand is greater than 1; the higher the elasticity, the closer the additional revenue is to the initial market price.

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KAREN BLEIER/AFP/Getty Images

What this tells us is that the difference between monopoly behavior and perfectly competitive behavior depends on the price elasticity of demand. A monopolist that faces highly elastic demand will behave almost like a firm in a perfectly competitive industry.

For example, Amtrak has a monopoly on intercity passenger service in the Northeast Corridor, but it has very little ability to raise prices: potential train travelers will switch to cars and planes. In contrast, a monopolist that faces less elastic demand—like most cable TV companies—will behave very differently from a perfect competitor: it will charge much higher prices and restrict output more.