Economic welfare is the base of two parties in trade. It can be quantified as the sum of consumer surplus and producer surplus.
Consumer surplus is the amount that a buyer is willing to pay for a product minus the amount the buyer actually pays while producer surplus refers to the difference between the price that a producer is willing to accept and the actual price. As we can see from figure 1, consumer surplus is the area below the demand curve and above the market price. However, producer surplus is the area above the demand curve and below the market price. Needless to say, the sum of the two parts is called economic welfare. Economic welfare will change while the market structure changes. In this essay, I will analyze how economic welfare changes if a market structure changing from perfect competition to a monopoly. However, whether the monopolist charges a single price or a multi price will affect the outcome.
Generally speaking, perfect competition is a market structure where there are a large number of firms and any individual firm, or any individual consumer, will have no effect on market price. It can exist in a market only if the following conditions are satisfied. Firstly, there are a lot of buyers and sellers. Secondly, buyers have perfect knowledge. Furthermore, units of the good sold by different sellers are identical and last, there are no barriers to entry into or exit from the market. Every firm is a ?price taker and thus had no influence on the market price. However, a firm in a competitive market, like most other firms in the economy, tries to maximize profit. As we know, at the profit maximizing level of output, marginal revenue and marginal cost are exactly equal. This is a general rule for profit maximization. Though in the short run, firms in the perfect competitive market may make a supernomoral profit or loss, in the long run, all the firms just can make a normal profit at an equilibrium price which is determined in the industry by the intersection of MC and MR curve. The reason is clear. In the long run, if firms are making supernomoral profits, new firms will be attracted into the industry as there is few barriers to enter. Thus firms have to reduce their price to ensure output. The price will fall until it gets to the equilibrium point where the market price is just equal to the firms long run average cost. I.e. firms can just make normal profit to cover their cost.
By contrast, a firm is considered a monopoly if it is the only seller of a good or service with no substitutes. A monopoly firm is a price maker while a competitive firm is a price taker.
The fundamental cause of monopoly is barriers to entry. It has three sources *Ownership of a key resource.
*Government gives a single firm the exclusive right to produce some good, such as patent and copyright laws.
*Costs of production make a single producer more efficient than a large number of producers.
Like a competitive firm, a monopoly maximizes profit by producing the quantity at
which marginal cost and marginal revenue are equal. Nevertheless, unlike a competitive firm, its price exceeds its marginal revenue, so its price exceeds marginal cost.
As we can see, perfect competition and monopoly are two absolutely different types of market structure. Which is more efficient? Which has more economic welfare? Firstly, have a look at figure 2 above.
There are two types of efficiency we should pay attention to—productive efficiency and allocative efficiency. Productive efficiency is achieved when the output is produced at a minimum average total cost. Clearly, from figure 2, we can easily get the conclusion that firms in perfect competition are more productively efficient.
However, economic welfare has a close relationship with the other type of efficiency—allocative efficiency. It is achieved when the value consumers place on a good or service equals the cost of the resources used up in production. (Price=Marginal cost) When this condition is satisfied, total economic welfare is maximized. Again, from figure 2, we may get the conclusion that allocative efficiency is maximized under perfect competitive conditions. As can be seen in figure 2, part of consumer surplus is transferred to producer surplus from the perfect competitive market to the monopoly situation. Monopolists control the quantity they produce in order to charge a high price. So they have not allocated the scared resources efficiently. What makes monopoly inefficient is the existence of the area that is a wedge between the consumers willingness to pay and the producers cost. It is called deadweight welfare loss. In monopoly, the price is higher; the consumer surplus is lower and the producer surplus is higher than a competitive industry. Moreover, the output is lower; the monopoly will lead to a lower overall level of economic welfare. Marginal cost is less that price, so there is allocative inefficiency.
Economics has championed the notion that the best guarantee of social welfare is competition, and perfect competition has always been its ideal
All of the above seems to imply that a monopoly necessarily leads to higher price, lower quantity, and deadweight losses relative to perfect competition. But this may not be true, because a monopoly may be able to achieve cost saving unavailable to smaller firms. Consolidation to serve larger number of consumers can allow the firm to take advantage of greater specialization, moving to a lower ATC and corresponding MC. A typical example is natural monopoly that exists when one firm can produce at a lower ATC than can two or more firms because of economies of scale. So we have two effects of greater concentration (fewer firms with greater market share each) in an industry. First, competition is reduced, which tends to drive price up. Second, cost savings may be realized from economies of scale, which tends to drive price down. Which effect dominates? This is an empirical question and highly relevant to many policy questions. Anyway, MC under monopoly is not always the same as under perfect competition. If it is lower, the economic welfare in monopoly will be much more that it is in perfect competition. Because the monopolist in this stage has lower cost thus they charge lower price and produce larger quantity.
In order to gain more profit, monopolists practices price discrimination. It is defined as charging different prices of a same product to different consumers on the basis of non-cost-related characteristics of the consumers.