6/28/11

Why monopolies are bad for consumers: a graphical approach part 2


In the first post we looked at monopolies and how they try to maximize their own profits, using consumer's demand functions.  Given this knowledge, monopolies choose to sell goods to a point where THEIR revenue is maximized, instead of the surplus (or happiness) of the economy.  In this post I will present the graph associated with monopoly output, and compare it to the output we would attain under perfect competition.  It will then be shown that when monopolies are present, consumers have less goods to purchase, as well as face higher prices.  The presence of a monopoly also lowers the total welfare of an economy.


The graph below shows the relationship between the various costs, and revenues of a monopoly and how they interact with consumer demand.
The blue box shows the monopoly's economic profit when they are allowed to function with no regulation.  This profit box is determined by finding where the marginal revenue line intersects the marginal cost line for the monopoly.  Normally to get an an efficient point for the economy, we want to be where marginal costs are equal to marginal benefits.

If you look at the Y axis (where prices and costs are represented), you will see three price levels.  The highest is the price the monopoly charges consumers for goods in a monopoly outcome.  The middle price is both the price charged to consumers, and the cost paid by the firm in a perfectly competitive outcome.  The lowest price is the cost paid by the firm in a monopoly outcome. 

If you look at the X axis (where the firm's output is shown), you will see two different quantity levels.  The highest level of output is achieved during the competitive market outcome where marginal benefit (shown by the consumer demand) is equal to marginal cost.  The lower quantity is achieved when the firm has monopoly power, and restricts output.

So this post has shown graphically why monopolies are bad for consumers.  It is because a monopoly can both reduce quantity supplied to the market (meaning less people get what they want), and at the same time charge higher prices for the goods that they do sell.  While this may seem obvious for some, economics is the science of explaining observed outcomes with models.  And this model definitely shows why what we see happening is occurring.


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