How does a monopoly contribute to market failure?
According to general equilibrium economics, a free market is an efficient way to distribute goods and services, while a monopoly is inefficient. The inefficient distribution of goods and services is, by definition, a market failure.
In a free market, the prices of goods and services are determined by open competition. Producers increase or decrease production according to consumer demand.
Key points to remember
- Some modern economists argue that a monopoly is by definition an inefficient means of distributing goods and services.
- This theory suggests that it obstructs the balance between producer and consumer, leading to shortages and high prices.
- Other economists argue that only government monopolies cause market failure.
In a monopoly, a single supplier controls the entire supply of a product. This creates a rigid demand curve. In other words, the demand for the product remains relatively stable, whatever the level (or low) of its price. Supply may be limited to keep prices high. This leads to under-supply or scarcity.
Thus, according to the general equilibrium economy, a monopoly can lead to a deadweight loss or a lack of balance between supply and demand.
In theoretical economics, under-supply, or scarcity, fails to measure up against the concept of perfect competition, which could be described as a balance of power between buyer and seller. Competitive pressure maintains “normal” prices, with consumer demand for the product or service setting that standard. The demand curve is elastic, rising or falling in response to price.
General equilibrium economics is a twentieth-century neoclassical theory that describes a specific, albeit unrealistic, notion of perfectly competitive markets. Classical monopoly theory was founded – and is normally still discussed today – in this tradition.
The perfect competition model is criticized as unrealistic and unachievable.
According to this theory, market failure occurs when power is concentrated in too few hands. A monopoly is a single supplier of a product or service. A monopsony is a single purchaser of a product or service. A cartelized oligopoly is made up of a few large suppliers who agree not to compete directly. A natural monopoly is an unusual cost structure that leads to effective control by a single entity.
In the real world, all of these variations are largely covered by the concept of monopoly. The concern is that a monopoly takes advantage of its position to force consumers to pay prices above equilibrium.
Many economists dispute the theoretical validity of general equilibrium economics because of the highly unrealistic assumptions made in perfect competition models. Some of these critiques extend to its modern adaptation, the Dynamic Stochastic General Equilibrium.
Milton Friedman, Joseph Schumpeter, Mark Hendrickson and other economists have suggested that the only monopolies that cause market failure are government protected.
The legal monopoly
A political or legal monopoly, on the other hand, can impose monopoly prices because the state has erected barriers against competition. This form of monopoly was the basis of the mercantilist economic system in the 16th and 17th centuries.
Modern examples of these monopolies exist to some extent in the utilities and education sectors.