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Economic efficiency in perfect competition and monopoly

Productive efficiency

Productive efficiency refers to a situation in which output is being produced at the lowest possible cost, i.e. where the firm is producing on the bottom point of its average total cost curve. Since the marginal cost curve always passes through the lowest point of the average cost curve, it follows that productive efficiency is achieved where MC= AC.

Figure 1 Equilibrium in perfect competition and monopoly

The diagrams in Figure 1 show the long run equilibrium positions of the firm in perfect competition and the monopolist. We can clearly see that for the perfectly competitive firm, productive efficiency automatically arises as in long run equilibrium MC=AC at point X. However, in the case of monopoly, the firm is not operating on the lowest point of its AC curve (point X ) but is instead operating on some higher point (point S). We can therefore conclude that in contrast to perfect competition, and assuming an absence of economies of scale, the monopolist will be productively inefficient.

Allocative efficiency

Allocative efficiency occurs where price equals marginal cost in all parts of the economy.

Again, with reference to Figure 1, it can be seen that in perfect competition, MR = MC, and MR = price. MC therefore equals price (at point Y), and allocative efficiency occurs. However, the monopolist produces where MC = MR, but price does not equal MR. It can be seen that at the equilibrium output of OQ, price is greater than MC by the distance RZ, and the monopolist could thus be said to be allocatively inefficient.

Dynamic efficiency

Both productive and allocative efficiency are examples of static efficiency in that they are concerned with how well resources are being used at a particular point in time. However, it is also important to consider how efficiently resources are being allocated over a period of time, when, for example, there may be technological advances, and this is the concern of dynamic efficiency.

Monopoly has been justified on the grounds that it may lead to dynamic efficiency. This is because the supernormal profits made will not only enable the monopolist to finance expensive research and development programmes but may also provide the necessary inducement to undertake such programmes in the first place. In contrast to this, firms operating in a perfectly competitive environment may lack the incentive to finance expensive research and development programmes, as open access to the market would mean that their competitors would immediately be able to share in the fruits of any success. The greater certainty of being able to earn supernormal profits in the long run also explains why levels of investment in capital projects may be greater in more monopolistic markets.

So can you now summarise the advantages and disadvantages of monopoly? Have a think about them, jot them down and then follow the link to compare your notes with ours.

Efficiency and market structure

We are concerned here with concentrated (monopoly and oligopoly) and competitive markets.

Competitive markets are considered to be statically efficient - both allocatively and productively. Dynamic efficiency is another matter. Because firms are all small, no one firm can afford R&D; it would have to be done on a collective or industrial basis. This has been done, but a number of problems arise over funding levies and charges.

Concentrated markets, on the other hand, are considered to be inefficient in the short-run. They are statically inefficient, even though their AC may be significantly lower than their smaller 'perfectly competitive' equivalent. The profit motive makes them strive to be more efficient, so they may invest in R&D and may be dynamically efficient

1

Monopoly vs perfect competition

In the diagram below, which area represents the level of consumer surplus under perfect competition?

a)
b)
c)
d)
e)
Please select an answerNo, that's not right. This is the consumer surplus once the monopolist has taken over the industry.No, that's not right. This is a part of the deadweight welfare loss when a monopolist takes over.Yes, that's correct. The consumer surplus is the triangle above the price line and under perfect competition, the price will be set where MC=AR.No, that's not right. This is the producer surplus under perfect competition.No, that's not right. This area does not represent either producer or consumer surplus.
Check your answer

2

Monopoly vs perfect competition

In the diagram below, which area represents the level of consumer surplus under monopoly?

a)
b)
c)
d)
e)
Please select an answerYes, that's correct. This is the consumer surplus once the monopolist has taken over the industry.No, that's not right. This is a part of the deadweight welfare loss when a monopolist takes over.No, that's not right. The consumer surplus is the triangle above the price line and under perfect competition, the price will be set where MC=AR.No, that's not right. This is the producer surplus under perfect competition.No, that's not right. This area does not represent either producer or consumer surplus.
Check your answer

3

Monopoly vs perfect competition

In the diagram below, which area represents the welfare loss if a monopolist takes over a perfectly competitive industry?

a)
b)
c)
d)
e)
Please select an answerNo, that's not right. This is the consumer surplus once the monopolist has taken over the industry.No, that's not right. This is part of the deadweight welfare loss when a monopolist takes over, but you also need to include area 5 as well.No, that's not right. The consumer surplus is the triangle above the price line and under perfect competition, the price will be set where MC=AR.No, that's not right. This is the producer surplus after the monopolist has taken over.Yes, that's correct. This area is the deadweight welfare loss if a monopolist takes over. The areas were previously part of consumer or producer surplus, but are lost once the monopolist takes over and limits output.
Check your answer