Market failuretypically happens when, in a free market, there is an inefficient distributionof resources. The market ends up with an outcome that is not Pareto optimal (TheEconomy, 2017).
Failure can occur because of a wide range of reasons and factorssuch as negative externalities, monopoly power, information failure (asymmetricinformation), as well as public goods. In particular, market failure can arisefrom a monopoly due to the inability to regulate its actions – this is what monopolyis. This essay will focus on monopoly power, how it is a form of marketfailure, the negative effects of it, and how this is dealt with throughgovernment intervention.
Monopoly power isessentially when a single firm has control of the market and so can set higherprices and because of this a monopoly market is the market condition that hasthe most imbalanced power (Nguyen and Wait, 2016). There are several types of monopolypower that can exist in a market. Firstly, there can be pure monopolistic powerwhere there is only a single seller in the market. There is also workingmonopolistic power in which the monopoly is any firm with 25% or more of totalsales.
An oligopoly is a market containing a few dominant firms and, finally,duopolistic power wherein two firms take the majority of the demand. Monopoly powereither comes from a business growing successfully on its own, or through the integrationof firms (mergers and acquisitions). The integration of firms happens when twofirms join together at the same stage of production or a firm integrates with differentphases of production. Monopoly power can be protected with barriers to entry;barriers to entry can block rival business from being able to profitably entera market which protects the power of the monopoly (Gabszewicz, 2000) and otherexisting firms as well as maintaining relatively high profits and increasing producersurplus. These barriers include predatory pricing, perpetual ownership of ascarce resource, and exclusive contracts, among many others. Overall, monopolypower is created and maintained through organic business growth, mergers andacquisitions, and barriers to entry.
A monopolymaximises profit in the long run at MR = MC. It sets the price at P1 and producesQ1, making a super-normal profit since AR > ATC. Monopoly power canlead to the monopoly being X-inefficient (Taylor, 2017), meaning the firm hashigher cost curves than if there was competitive pressure. Since the monopoly doesnot face any current or potential competition, a consequence of this can be thefirm suffering X-inefficiency due to the workers putting in less effort thereforecausing costs to rise.
A lack of competitors in general gives a monopoly fewerincentives to cut costs as well as to develop better or new products andservices. In addition tothis, monopoly power means the monopoly could restrict output in order to raiseprices which in turn leads to the loss of producer surplus as well as consumersurplus. In a monopoly, the producer has the power to set the good at anypossible price (Stuart, 2007) due to the fact that consumers do not haveanywhere else to buy the good from. The price set by the producer or firm isusually a lot higher than both the average and marginal costs thus leading to allocativeefficiency being lost and hence a market failure.
Furthermore, monopolypower leads to market failure through misallocation of resources but it alsoleads to welfare loss. Higher prices not only mean that the consumer’s wantsand needs are not being satisfied because the product is being under-consumed,but they also cause a loss of consumer surplus and welfare which unduly affectsfamilies of a lower income as super-normal profit is inequitable and can beseen as an imbalanced division of resources in society (Tore, 1991). The welfare lossas a result of monopoly power market failure is represented by triangle ABC inthe diagram above, it is also known as ‘The Deadweight Loss’ (DWL) Triangle.The area in the triangle above the line PB represents the loss in consumersurplus, while the area below shows the loss in producer surplus. The totalwelfare loss associated with monopoly power is the loss in consumer surplus plusthe loss in producer surplus which equals to the DWL Triangle (Shughart, 1999).
Because of theinequality of income and the welfare losses that result from from monopolypower market failure, there is the need for monopoly to be controlled andregulated. This is done through government intervention and is done mainlythrough taxation, regulation of conditions of monopoly, and anti-monopoly lawsand policies being put in place to prevent any unfair price discrimination forconsumers. The government isable to regulate monopoly power through the use of taxation by either levying atax per unit of output – known as Specific Tax – or by imposing a lump sum,irrespective to output, tax. Specific tax is principally a commodity tax suchas sales tax which is tax on sales and excise duty tax which is levied onproduction. Specific tax typically has the effect of reducing outputs sold, theprice consumers are charged increases so that the burden of the tax is notsolely on the firm, and a reduction in profit for the monopoly (Koutsoyiannis,1975). A Lump Sum tax can be something like a profit tax or even a license feewhich is enforced on a firm irrespective of its level of output and so it istreated by the monopoly as if it were a fixed cost (meaning it isn’t includedin the firm’s Marginal Costs). Another way thegovernment intervenes is with price regulation.
An example of this is RPI-X(Anderton, 1993), a form of price capping which is usually used for privatisedindustries. The amount that the price has to be cut by is X and it is in realterms. For example, if RPI was 6% for a specific year and X was to be set at2%, this would mean that the firm can only increase its prices by 4% (= 6% – 2%).An advantage of price regulation such as RPI-X is that firms will opt to tryand cut their costs by more than X in order to increase their profits which inturn means they become more efficient. Price regulation is an incentive tolower costs and can inspire market competition preventing firms from abusingmonopoly power.
The government canalso ensure that profits earned are not excessive, for example through the useof corporation tax on any profits earned. Moreover, government regulators canmake sure that minimum standards are met and check the quality of goods andservices produced by the monopoly. Sometimes, performance targets are also seton organisations in order to regulate quality. For example, the NHS is amonopoly power but is highly regulated and is set huge performance targets bythe government.
There is also alot of legislation and a number of policies that have been put in place by thegovernment, as well as bodies created by the government and independently, toprevent market failure from monopolies and to further regulate them. TheCompetition Act 1998 prohibits a wide range of activities by firms including afirm abusing its dominant position as well as colluding with competitors (Klein,Dalko and Wang, 2012). The Office of Fair Trading (OFT) is an independent bodywith some of its main objectives being to investigate any abuse of market powerfrom a firm with a dominant position and to investigate any practices of anti-competitivenesssuch as restrictive practices. There is also the Competition Commission whoassess whether or not a merger will reduce competition. Government interventionand regulation of monopoly power can prevent market failure, sometimeseliminate deadweight loss (Hill and Myatt, 2010), and in some cases there canbe more positive outcomes from monopoly power.
With a firm having such highprofits, they can potentially be used to fund innovation causing gains indynamic efficiency. Economies of scale could also be achieved – meaning averagecosts are lower. Further to this, competition could stem from elsewhere such asoverseas.
In conclusion, monopolypower, without any regulation or intervention from the government, will lead toa market in which resources are completely inefficiently allocated so accordinglythe final outcome will be market failure with significant welfare losses; themost important of which is inequality of income. To prevent this market failureand unfortunate welfare losses that result from monopoly power, the governmentimposes various taxes on monopolies and laws which closely regulate theirprices and activities.