Describe Monopoly and Monopolistic Competition,

and assess these market structures in terms of their

allocative efficiency.
By Aditya Joshi - 1921143

Monopoly
Monopoly can be defined as a market structure where there is a single seller selling a product
for which there is no close substitute available and there are barriers to enter the market.
Presence of a single firm shows that there is no difference between a firm and an industry.

A monopoly has the following features:

1. Single Seller
In a monopoly, there is just one seller of a product or service. As a result, there is no
difference between firm and industry. The demand curve facing the monopolist is thus
the market demand curve. The monopolist fixes the price and quantity where it
maximizes its profits. However, out of the two variables, price and quantity, a monopolist
can fix any one. If it fixes the price, the quantity is determined by the market and if it fixes
the quantity to be sold, the price is determined by the market.
2. No Close Substitutes
For a monopolist to retain its position in the long run, it is essential that the firm must sell
a unique product which cannot be substituted by any other product or service.
3. No Entry
A monopolist usually earns supernormal profits in the long run as there are restrictions to
the entry of new firms in the industry. So, the profit earned by the monopolist is not
wiped out as is the case of perfect competition, where presence of supernormal profits
attracts new firms in the industry.
4. Goal of Profit Maximization
The sole goal of a monopolist firm is to maximize the profits.
5. Absence of Supply Curve
In perfect competition, there was a one to one relation between price and quantity
supplied. Such a relation is absent in case of a monopoly as the quantity supplied is
dependent upon the elasticity of the demand curve and shape of the marginal cost.
Thus, the same quantity can be supplied at two different prices or two different quantities
can be supplied at the same price showing that there is no supply curve in monopoly.
 Allocative Efficiency in Monopoly
Allocative Efficiency occurs when there is an optimal distribution of goods and services, taking
into account consumer’s preferences. We can say that allocative efficiency is at an output level
where the Price equals the Marginal Cost (MC) of production. This is because the price that
consumers are willing to pay is equivalent to the marginal utility that they get. Therefore the
optimal distribution is achieved when the marginal utility of the good equals the marginal cost.

In case of perfect competition, a firm sells a product at a point where Price (P) is equal to
marginal cost (MC). There is no exrta cost to the society. A monopolist however sells at a price
that is greater than its marginal cost as is shown in the figure below. The demand curve of a
perfectly competitive industry is downward sloping and the supply curve obtained from
summation of the marginal cost curves is upward sloping. Equilibrium of the industry is where
demand is equal to supply, it gives OQ​pc​ quantity at OP​pc​ price. If it would have been a
monopoly, the equilibrium would be at a point where marginal revenue and marginal cost are
equal, as established in Point A in the figure where the monopolist is selling OQ​m​ quantity at a
price of OP​m​. It can be seen that a monopolist sells lesser quantity as compared to perfect
competition and that too at a higher price. This leads to the cost that society has to bear and is
termed as allocative inefficiency of the monopoly market.

There are two costs that arise because of monopoly:

1. Dead Weight Loss
2. Rent Seeking
Dead Weight Loss
It is the net loss to the society that includes both producers and consumers. To understand the
concept of dead weight loss, we need to explain consumer surplus and producer surplus and
see how these changes because of monopoly power.

Consumer Surplus: The difference between the price that consumer is willing to pay and what
he actually pays is known as consumer surplus. Graphically, it can be located as the difference
between the demand curve and the equilibrium price.
Producer Surplus: The difference between the price that producer actually gets and the price at
which he is willing and able to sell is called producer surplus. Graphically, it can be located as
the difference between the equilibrium price and the marginal cost (supply) curve.

To see how there is a change in the consumer and producer surplus on conversion of a
perfectly competitive industry to monopoly assuming the same demand and cost conditions we
make use of the given table.

Consumer Surplus Producer Surplus

Perfect Competition (Before) A+B+C+D+E F+G+H

Monopoly (After) A+B C+D+F+G

Change (After – Before) –C–D–E C+D–H

Net Change = – C – D – E + C + D – H = – H – E = Dead weight loss

Initially we assume that there is perfect competition in the market. The demand curve AR and
supply curve are given by M​c​, equilibrium is where demand and supply curve intersect which is
given by E​pc​. Equilibrium quantity is Q​pc​ and price is P​pc​. Here the consumer surplus and
producer surplus are given in the table. Now if all the firms under perfectly competitive industry
are undertaken by a monopolist assuming that demand and cost conditions remain same, the
equilibrium is obtained by intersection of MR and MC which is at E​m​ giving equilibrium quantity
as Q​m​ and price as P​m​.

It can be seen that the monopolist is selling a lesser quantity and that too at a higher price. The
new consumer surplus and producer surplus is shown in the table. To find out whether
consumers or producers are at loss or gain we calculate the change in consumer and producer
surplus. It is seen that consumer surplus has reduced by C + D + E, the reduction of C + D
being because of a higher price that consumers now have to pay while reduction in E is
because of reduction in the quantity as now few consumers have to do without the commodity.

Producer surplus, on the other hand, has increased by C + D but reduced by H. The increase of
C + D is because of higher price that producers get now; it is actually just a transfer from
consumers to producers (a zero sum game) and loss in H is because of reduction in quantity
that producers sell now. To find out whether society as a whole is at gain or loss, we add the
change in consumer and producer surplus and find out that society at large is at a loss of H+E,
this being the dead weight loss or cost to the society because of monopoly.

Rent Seeking
Rent seeking is the behaviour in which households or firms take action to preserve profits. Rent
seeking is a byproduct of political legislation and government funding. Rent seeking can disrupt
market efficiencies and create pricing disadvantages for market participants. It has been known
to cause limited competition and high barriers to entry.

Monopolistic Competition
Monopolistic competition is a market structure which combines elements of monopoly and
competitive markets. Essentially a monopolistic competitive market is one with freedom of entry
and exit, but firms can differentiate their products. Therefore, they have an inelastic demand
curve and so they can set prices. However, because there is freedom of entry, supernormal
profits will encourage more firms to enter the market leading to normal profits in the long term.

Monopolistic Competition has the following features:

1. Number of Firms and Customers
There are a large number of buyers and sellers in the market as the demand is high and
there is no restriction to the entry or exit of a firm.
2. Product Differentiation and Close Substitutes
The firms under monopolistic competition sell differentiated products which are close
substitutes of each other. Close substitute products are those products whose uses,
production technology and respective prices are almost similar. However, these products
can be different in terms of presentation, style, packaging, colour and branding etc. For
 example, take the product toothpaste. There are several varieties of toothpastes
available in the market but their use is the same. Their prices and production
technologies are similar as well. However, two different toothpastes differ in terms of
style, taste, colour and branding.
3. Selling Cost
Firms under monopolistic competition incur selling cost besides production cost in the
form of advertising, dealership or for adoption of other marketing strategies. The aim is
to create an edge over other firms in the market with respect to profit making and having
larger market share. Both product differentiation and selling cost give a particular firm
some degree of monopoly power in the market to compete with other firms.
4. Entry and Exit of Firms
There is free entry into and exit from the market.
5. Price and Non-price competition
Firms under monopolistic competition are seen to be indulging in both Price and
Non-price competition. Price competition takes the form of price cutting or discounts
while non-price competition can take the form attracting customers by offering gifts,
offers, sponsporships and popular endorsements.
6. Lack of Perfect Knowledge
There is a lack of perfect knowledge in the consumers about the cost of product,
demand and other market conditions.
7. Lack of Mobility
There is an absence of perfect mobility of factors in the market due to lack of perfect
knowledge.

Allocative Efficiency in Monopolistic Competition

Markets that have monopolistic competition are inefficient for two reasons. The first source of
inefficiency is due to the fact that at its optimum output, the firm charges a price that exceeds
marginal costs. The monopolistic competitive firm maximizes profits where marginal revenue
equals marginal cost. A monopolistic competitive firm’s demand curve is downward sloping,
which means it will charge a price that exceeds marginal costs. The market power possessed by
a monopolistic competitive firm means that at its profit maximizing level of production there will
be a net loss of consumer and producer surplus.

The second source of inefficiency is the fact that these firms operate with excess capacity. The
firm’s profit maximizing output is less than the output associated with minimum average cost. All
firms, regardless of the type of market it operates in, will produce to a point where demand or
price equals average cost. In a perfectly competitive market, this occurs where the perfectly
elastic demand curve equals minimum average cost. In a monopolistic competitive market, the
demand curve is downward sloping. In the long run, this leads to excess capacity.