and starts to rise only at very large output levels. Again, the profit-maximizing monopolist sets MC = MR to maximize profits and earns supernormal profits at price P m and output Q m.

This ability to earn supernormal profits under monopoly market structure can be a major cause of concern for governments and competition watchdogs since such profits imply lower consumer surplus than if profits were lower.

6.3.3PERFECT COMPETITION VS. MONOPOLY

The extent of the impact on welfare and consumer surplus is evident from Figure 6.5 where perfect competition and monopoly market structures can be compared and contrasted.

One striking difference between monopoly and perfect competition is the equilibrium price and output levels when facing an identical market demand curve.

Under monopoly price is higher and output is lower than under perfect competition.

This implies that consumer surplus is lower and producer surplus higher under monopoly, due to this redistribution of income away from consumers and towards the monopoly producer. There is also an area that is lost completely in welfare terms, which neither consumers nor producers gain: defined by the triangle abc. This is called a deadweight loss.

A deadweight loss represents the welfare lost to society from relatively inefficient production.

F I G U R E 6 . 5 P E R F E C T C O M P E T I T I O N A N D M O N O P O L Y C O M P A R E D

Unlike under perfect competition, a monopoly firm does not produce at maximum efficiency since it does not produce at the minimum point of the AC curve (Q pc ). Hence, resources are not used at maximum efficiency since under monopoly output is restricted.

Given these seemingly negative consequences of monopolies, why do they exist at all? Because the underlying assumptions of product homogeneity and free entry and exit in the perfect competition model rarely if ever hold true in the business world!

The challenge for the economic system is to acknowledge that perfect competition is not achievable and to ensure that the beneficial effects of competition are maximized.

Barriers to entry exist in many industries and these impede the ability of new firms to come into the market and bid down price.

Barriers to entry may be based on:

•Type of product: standardized versus differentiated products. The ability of firms to differentiate their products and thereby create brand loyalty can make it difficult for new entrants to gain a foothold in a market, especially if consumers are unwilling to switch from a brand they know and trust.

•Economies of scale: Some industries require the firm to produce a relatively large output in order to operate at or near the minimum point of their average cost curve. In this case the ability of the firm to secure a large output will determine whether they can profitably enter the market. In the extreme case of the average cost curve continuing to fall over large output ranges, only very large firms could compete or, in the natural monopoly case above, just one firm would be profitable.

•Experience curve effects: Sometimes experience by the incumbent firm in the industry can result in lower average costs for that firm. New entrants who therefore do not have this experience are faced with higher average costs. This puts them at a competitive disadvantage.

•Capital requirements: Some industries require a large amount of initial capital in order to set up production. A firm’s ability to access such capital may determine their ability to enter the market.

•Cost disadvantages independent of size: Incumbent firms may have longestablished relationships with suppliers or distributors that give the firm valuable access to important resources. Dealing with a long-established

supplier over a period of time can provide the firm with access to a reliable source of high-quality raw materials at competitive prices at a time that suits the firm’s production schedule. A new entrant, not having such access, may be at a competitive disadvantage.

•Legal protection: The firm’s ability to secure patents can prevent a new entrant from competing in the market. Licences granted by, for example, national governments, or trade agreements between countries would have similar effects.

Benefits from monopoly?

Despite the potentially negative aspects of monopolies, there are instances where monopolies generate economic benefits. Central to the positive aspects of monopolies is their potential for innovation, emphasized by Schumpeter. The supernormal profits that monopolies earn can be used for investment into R&D facilities. However, this is only a positive result for society if firms carry out such investment rather than squandering their profits. There are some incentives that may encourage monopoly firms to invest, at least, a proportion of their profits back into the firm and these incentives centre around the ability to earn higher profits in the future as a result of successful innovation and thereby securing their dominance in the market.

Other arguments in favour of monopolies centre on their ability to exploit economies of scale in production such that society reduces wasteful inefficiencies. If a monopolist can gain efficiencies over and above those that could be gained in a perfectly competitive market (if small output shares are produced only at relatively high average cost) then monopolies have advantages. Coupled with such advantages is the potential, which always exists in monopolies, to exploit a market position and in doing so harm consumer interests. Critics of monopolies point to this potential damage as outweighing any potential advantages and will therefore be sceptical of them, especially as there are many cases where innovation and R&D take place in non-monopolistic industries.

6.3.4MONOPOLISTIC COMPETITION

Markets characterized by monopolistic competition, first described by Edward Chamberlin, involve many sellers producing products that are close, but not perfect substitutes – there is product differentiation. Each firm has a monopoly in its own variety of the product. Examples of monopolistic competition include restaurants, petrol stations, corner shops and builders. This market structure is illustrated in Figure 6.6.