Market failure is a situation when the price mechanism fails to allocate scarce resources efficiently or when the operation of market forces leads to net social welfare losses or to deadweight loss of economic welfare1. Markets can fail for many reasons namely, information failure, negative externalities, public and quasi-public goods, factor immobility and monopolies. Here, we will focus on monopoly power as the direct cause of market failure, how it creates welfare losses and what the governments can do to rectify the failure.
A monopoly is a market dominance which leads to the underproduction and overpricing of a good, damaging consumer welfare. It includes a single seller, high barriers to entry, no close substitutes for the good, and is a price maker. A pure monopoly occurs where there’s a sole supplier holding 100% of the market shares, though cases of this are rare. Monopoly power, however, is more widespread and can exist even if there’s more than one supplier such in markets with two dominant firms, a duopoly, or with a few firms, an oligopoly. For regulatory purposes by the Competitions and Markets Authority (CMA) in the UK, a firm is said to have ‘monopoly power’ if it has more then 25% of the market shares. For example, Tesco has 30% market shares or Google, 90% of search engine traffic.2 According to Adam Smith, the monopolies generally tend to seek out ways to increase their profits even at the expense of consumers, thus, generating more costs to society than benefits.3 A monopolist will try to achieve the profit-maximizing output at Marginal Cost (MC) = Marginal Revenue (MR which causes the monopoly price to be higher than the average and marginal cost of production, leading to a loss in allocative efficiency.
The under-provision and overpricing of the good causes a loss in consumer surplus and a gain in producer surplus and an overall net loss in welfare as displayed in figure 1 and 2 below. Figure 1 Figure 2Figure 1 shows a firm in a perfectly competitive market, while figure 2 is that under a monopoly. In a competitive market, when the firm produces at Pc, it will supply a quantity of Qc, where the supply curve and the demand curve meet. Consumer surplus is shown as the yellow areas (a + b + c) and the producer surplus, the orange areas (d + e). Now let’s consider that in the case of a monopoly as shown in figure 2.
A third color, grey, is added to show ‘deadweight loss’, the area lost from which in the competitive market, was surplus to consumers or producers. Consumer surplus is now area (a) only, producer surplus areas (b + d) and the deadweight loss, areas (c + e).Evidently, going from a perfect competition to a monopoly is bad for consumers as their surplus is reduced by (b+c). This is good for the producers however as the area (b) has gone from the consumers to the producers, increasing the producer surplus by (b-e). There is an allocative inefficiency because less output is produced due to the quantity decreasing from Qc to Qm. So, there is a net welfare loss when the aggregate welfare if consumers and producers are taken into account and overall society loses out. Thus, there is a loss of efficiency when perfect competition is taken over by a monopoly.
4 Besides that, monopolies are also productively inefficient as monopolists face little to no competition and thus has no incentive to reduce costs of production to the minimum. This leads to possible X-inefficiencies where in theory, a firm could achieve average cost (AC) at the potential average cost curve but due to managerial slack, actual AC is higher. The difference between the potential and actual AC is the X-inefficiency.Figure 3.5 The supernormal profits monopolies make leads to a great income distribution inequality and could cause social friction. Firms might also lack the incentive to innovate as they face little to no competition, thus delaying technological advances.
In a study by the National Bureau of Economic Research in 2017, it was found that U.S. businesses have invested less than expected since 2000 partly due to the lack in competition.6 An example being the cable industry who was a monopoly but because of their lack of innovation, got beaten down by the disruptive technologies like Netflix and DishTV who created a new type of entertainment service which didn’t require cables. Furthermore, a monopoly could also face diseconomies of scale if the firm grows too fast and becomes too big to coordinate properly. Therefore, there are many reasons as to why monopoly can be viewed as a cause of market failure. To correct this market failure, government interference is vital.
They could implement laws, merger policies, price caps, and carry out nationalization or deregulation. In the UK, based on the Competition Act 1998, the OFT is to investigate any collusive behavior or abuse in market power. In this context, the OFT would investigate when predatory pricing, overcharging of prices, vertical restraints or tie-in-sales.7 The Sherman Act 1890 with their Anti-trust laws also prohibited certain outcomes and behaviors of a monopoly, however, on its own initiative. A monopoly that came into power because of its own skill and hard work is considered an innocent monopoly and the Act only punished coercive monopolies that intentionally dominated the market through misconduct and ill-intention toward the society.
8 Merger policies prohibit the mergers of firms that will create a combined more than 25% of the market shares and is believed to be against the public interest. This policy acknowledges the right of the OFT to investigate any mergers that could create a monopoly power and refer them to the competition commission to decide whether to allow, block or allow it under conditions such as divesting some parts of the business to keep the market share low. For instance, in 2007, the UK Competition Commission decided that Sky would be forced to sell some of its 17.9% stake in ITV.
9 Governments also regulate monopolies by price capping previously state owned monopolies like gas and water using RPI-X regulators. Established regulatory bodies such as OFGEM (for the gas and electricity markets), OFWAT (tap water), ORR (office of rail regulator) function to limit price increases, using the formula RPI-X, where X is the amount they have to cut prices by in real terms. For example, if inflation was 3% and X=1%, firms are allowed to increase their prices by (3%-1%)=2%. If the regulators think the firms can make efficiency savings and are charging consumers at too high a price, they can set a higher value of X to regulate the prices as was done in the early years of telecom regulation.Governments can also nationalize monopolies that are exploiting the consumers, by taking over the company. A privatized natural monopoly could exploit its market power by setting high prices to the consumers. Thus, to prevent this exploitation, the natural monopoly is put under government ownership as they can run the industries to the best interest of the society. Most natural monopolies such as railways, steel, and electricity, where it is the most efficient to have only one firm in the industry have been nationalized.
This is the case in 1967 when over 90 of steel capacity was put under the control of the British Steel Corporation (BSC).10On the other hand, inefficient government-owned monopolies with weak productivity growth is deregulated, often accompanied by privatization. This lowers the legal barrier of entry and makes the market more contestable. New entrants are introduced to the market and with more competition, technological innovations and advancements can be made in the industry. Inefficiencies are reduced and as a result, costs and prices can be driven down. This can be seen in the deregulation of the mail delivery monopoly, Royal Mail that had a legal monopoly on delivering mail and parcels in the UK. In 2006, the market was made contestable and any licensed operator is allowed to deliver mail to businesses and residential customers, introducing the Royal Mail to competition like TNT mail and UK Mail.
11Therefore, it is evident that monopolies are always viewed negatively as a cause of market failure commonly associated with the notions of high prices, anti-competitiveness and excessive profits. However, monopolies are sometimes preferred over competitive market structures like in cases of natural monopoly and when the firm achieve monopoly power by being the best provider of the good or service. This is the case with modern monopolies like Google, who achieved monopoly power through being regarded as the best firm for search engines and Apple, as the best producer of digital goods.12 They don’t own their own supply chains and instead create their value by connecting their users.
Thus, it can be said that monopolies aren’t always bad but even so, regulations still need to be in place to keep monopolies on their toes.