MONOPOLY

Monopoly

Monopoly

Economic theory suggests that monopoly results in a social loss because output is restricted below its optimal level, meaning that marginal benefit and marginal cost are not equated. Traditionally this social loss has measured in terms of the deadweight loss (DWL) of monopoly. However, this measure of social loss assumes that the monopoly is costlessly created and maintained. In fact, the opportunity to earn monopoly rents results in resources being invested in unproductive activities in their pursuit. In other words, rent seeking occurs. This essay examines the theory of rent seeking as applied to monopoly. The types, cost implications and solutions to rent seeking are discussed in turn. In conclusion, it will be evident that the costs of rent seeking are largely determined by the precise nature of the rent seeking game.

The Social Cost of Monopoly

The theory of monopoly states that a monopolist earns supernormal profits by restricting output and hence increasing prices above its perfectly competitive level.

Figure 1.

When price rises above this level, a transfer of income from consumers (who continue to consume the good) to the monopolist (measured by area A in the diagram) occurs. A further loss, known as the deadweight loss (shaded triangle), is incurred by people who stop buying the product. This refers to the consumer surplus that would have been generated by consumption of the good between Qm and Qpc, a quantity now neither produced nor consumed. However, this analysis hinges on the assumption of the monopoly being created and maintained costlessly. In fact, the deadweight loss underestimates the social cost of monopoly as the existence of an opportunity to earn monopoly profit (or rent) attracts resources into efforts to obtain and maintain monopolies. This activity is known as rent seeking. Furthermore, resources may be expended wastefully by opponents to the creation of a monopoly; in other words, a reaction such as "rent protection" may be provoked.

Tullock (1967) employs the analogy of theft to explain the problem of rent seeking. The transfer of wealth from victim to thief involves no social loss; it is a direct transfer and, summing over all individuals, society's wealth remains unchanged. However, the opportunity for such transfers encourages the thief to invest his resources (human capital and tools) in theft, that is he engages in rent seeking. The potential victim, meanwhile, aware of the possibility of theft, will invest in locks, and alarms to prevent the transfer of wealth, i.e., rent avoidance. The fact that both parties have employed resources unproductively implies a social loss to society, regardless of the outcome. From a societal point of view, it would be much more beneficial if the threat of theft was absent and both parties invested in the production of goods merely for society's consumption. The net result is the inefficient use of resources by society, and therefore a location off the production possibilities frontier.

What types of costs?

Any cost incurred in the competition to obtain or maintain a monopoly is a cost of rent ...