Reasons for inefficiency in monopolies Essay

1 Reasons for inefficiency in monopolies 1. 1 Monopolies and pricing A monopoly prices its products where marginal costs meet marginal revenues to maximise profits. Due to the fact that this price is higher than the market price in perfect competition, many consumers are not able or willing to buy at the higher price. This deadweight loss is an allocative inefficiency. Figure 1: Pricing in monopolies and perfect competition The consumer surplus in perfect competition is 1+2+4, and the producer surplus is 3+5. The consumer surplus in a monopoly is 1, the producer surplus is 2+3, and the deadweight loss is 4+5. 1. 2 Monopolies and productive efficiency In theory, a monopoly does not have to be less (productive) efficient than perfect competition. In reality, however, almost all monopolies tend to be inefficient. This may be for the following reasons: 1. 2. 1 Pressure for productive efficiency In perfect competition the price within an industry is determined by the market, or in other words, by demand and supply. Profit maximisation is achieved where the marginal cost curve intersects the demand curve (see figure 1). This means that in perfect competition, the company maximises its profit at the minimum point of its average cost curve. A company in a perfectly competitive environment tries, therefore, to be as efficient as possible in order to meet the minimum average cost. This causes a lot of pressure to achieve productive efficiency. A company in a monopolistic environment is able to change not only its cost, but also its prices. There is far less pressure for productive efficiency. 1. 2. 2 Diseconomies of scale A monopoly may increase its output to the point where it exceeds the minimum point of cost on its long-run average total cost curve. In this case, diseconomies of scale occur. 1. 2. 3 X-inefficiency. In perfect competition, X-inefficiency of one market participant will have almost no influence on the market and the market price. X-inefficiencies in a monopoly increase cost and, therefore, price. X-inefficiencies are more likely in monopolies because there is no benchmark to monitor the performance of management and less pressure from shareholders and markets. 1. 2. 4 Principal Agent There are no benchmarks and most shareholders and regulators do not have the insight into the company to evaluate management. 1. 2. 5 Case study: Deutsche Post AG (DPAG), Germany. The privatisation of most regulatory monopolies during the last few decades shows that competition decreases costs: Figure 2: Deutsche Post AG: Postal items delivered and employees (FTE) 1999-2005 The Deutsche Post AG lost its monopoly on the delivery of letters over 100 grams in 1998 and on the delivery of letters between 50-100 grams in 2005. From 1999- 2005, employees were reduced by 16% despite the fact that the total number of items delivered increased by over 3%. This means that during the monopoly the DPAG had a lower productive efficiency, delivering fewer items with more people and higher costs.