Market Structures, Costs and Revenue: Question 5

Worked solution

Part (a): Why perfect competition tends to be efficient and monopoly generally is not

Perfect competition. In long-run equilibrium, every firm is a price taker, so its average revenue curve is horizontal at the market price and marginal revenue equals price. Each firm profit-maximises where marginal cost equals marginal revenue, so it produces where price equals marginal cost. This is allocative efficiency, because the price consumers are willing to pay for the last unit (which reflects the value they place on it) exactly matches the cost of the resources used to produce it, so resources are allocated according to consumer wants.

Because entry and exit are free, any supernormal profit in the short run attracts new firms, increasing supply and driving price down until it equals average cost, leaving only normal profit. This process of entry continues only until price has been driven down to the minimum point of the average cost curve. This is productive efficiency, because the firm produces at the lowest possible average cost, using the fewest resources per unit of output.

Monopoly. A monopolist is the sole supplier and faces the whole (downward-sloping) market demand curve as its average revenue curve. Because selling an extra unit requires cutting price on all units sold, marginal revenue lies below price at every output. The monopolist still profit-maximises where marginal cost equals marginal revenue, but since marginal revenue is below price at that output, price ends up above marginal cost. Allocative inefficiency, since consumers value the last unit produced more than it costs to make, yet output is restricted below the level that would equate the two.

High barriers to entry also mean that, unlike in perfect competition, supernormal profit is not competed away in the long run: there is no guarantee that competitive pressure will push the monopolist to produce at the minimum point of its average cost curve, so productive efficiency is not guaranteed either.

Part (b): Is monopoly always less efficient?

The theoretical comparison above suggests monopoly is less efficient than perfect competition, but two considerations can weaken or reverse this conclusion.

Economies of scale. A monopoly, particularly one operating at a very large scale (sometimes described as a natural monopoly), may be able to spread large fixed costs (for example, in infrastructure or specialised equipment) over a far greater output than any single small firm in a competitive industry could achieve. If this pushes the monopolist’s average cost curve well below the average cost curve available to the many small firms of a perfectly competitive industry, the monopolist may still be able to charge a price below what the fragmented, smaller-scale competitive industry could sustain, even while charging a price above its own (lower) marginal cost. In such a case, consumers could conceivably end up no worse off, or even better off, under monopoly.

Incentive to innovate (dynamic efficiency). Because a monopolist can retain supernormal profit in the long run, it may have both the financial resources and the incentive to invest that profit in research and development, potentially lowering costs or improving the product over time, a form of dynamic efficiency. A perfectly competitive firm, earning only normal profit in the long run, may lack the retained profit needed to fund significant innovation, even if it wanted to.

Reasons to be cautious about these benefits. Neither benefit is guaranteed. Without the discipline of competition, a monopolist may instead become X-inefficient (its actual average cost may run above the theoretical minimum shown on its cost curve, because managers face no competitive pressure to eliminate organisational slack or unnecessary cost. A monopolist could also simply retain supernormal profit rather than reinvesting it in genuine innovation. The degree to which the market remains contestable) threatened by potential entrants even if actual entry is currently absent. Also matters: a contestable monopoly market may still behave close to competitively.

Conclusion. Monopoly is not always less efficient than perfect competition. Whether it is depends on the extent of any genuine economies of scale relative to the size of the allocative inefficiency created by pricing above marginal cost, whether supernormal profit is actually reinvested to produce dynamic efficiency gains, and how far X-inefficiency and market contestability offset these potential advantages in practice.

Final answers

• (a) Perfect competition: long-run entry/exit drives price to minimum average cost (productive efficiency) and price to marginal cost (allocative efficiency). Monopoly: barriers to entry protect supernormal profit and price is set above marginal cost at the profit-maximising output, so neither form of efficiency is guaranteed.
• (b) Not always. Genuine economies of scale or profit reinvested into innovation (dynamic efficiency) can offset monopoly’s allocative inefficiency, but this is undermined where the monopolist becomes X-inefficient or fails to reinvest profit, so the outcome depends on the specific market.