Monopoly and Perfect Competition Efficiency

Efficiency is a technical relationship between input and output. To be the technically efficient is when you produce maximum output with the minimum input. Another way of being efficient is being allocatively efficient. This is when a firm produces at the minimum point on its Average cost curve. Perfect competition is when there are a large amount of firms in the industry all producing the same homogenous good. In a monopoly there is only firm in the industry, and it is the sole supplier. This essay will look at the structure of the perfect competition and assess it efficiency. Then we will look at the structure of the monopoly and how efficient it is also. This essay will argue that on balance, perfect competition is more efficient then a monopoly.

A perfect competitive industry has certain characteristics. There are many buyers and sellers in the industry. There is perfect knowledge throughout the industry. All products are homogenous goods. There is free entry and costless entry into the industry. All firms in the industry are interested profit maximisation only normal profits will be able to be made in the long run. This is because, if there are supernormal profits being made in the short run, due to an increase in demand, new firms will be attracted by these profits. Due to perfect knowledge and free entry into the industry these new firms will enter, reducing each firm’s individual demand until profits are at a normal level. Similarly if there is a fall in market demand, so all firm makes a loss, due to the costless exit, firms will leave due to costless exit, reducing each individuals firms loss until normal profit is reached. Each seller is a price taker. They believe that what they contribute is so small, that it does not affect overall market price. The greengrocer selling bananas for 25p per kilo believes that his actions do not affect the overall market price for bananas. If an individual seller tries to raise the price level of his quota of bananas to 26p per kilo, his total revenue will be zero. This is because the many consumers have the perfect knowledge to know that they can buy the homogenous bananas from another banana seller at 25p per kilo. The result of this is that each individual firm has a perfectly elastic demand curve. This means that the marginal revenue curve of the firm will be a straight horizontal line. For every extra unit of output sold the firm receives the same amount of marginal revenue. The average revenue curve will look the same. This is because that average revenue will be constant. If the firm receives the same amount for each extra unit, so on average the amount per unit will be constant. As said earlier the rational perfectly competitive firm will manufacture at the profit maximising stage of output. Now, this is the level of output when the MR curve is equal to the MC curve. As any output either side of this point would mean a firm could make more profit producing more where marginal revenue is greater than marginal cost, so production should increase. The firm would make lower profit by producing at a level where the marginal cost curve leads the marginal revenue curve. The above information can be shown on the diagram below.

Price

MC

AC

MR=AR=D

P*

Q* Output

The diagram shows that the perfectly competitive firm is producing at output level Q* and price level P*. At This level the firm is allocatively efficient as it is producing at the minimum point on its AC curve. The firm is also being technically efficient as it maximising output, by producing where AR=AC, but is doing this by producing with minimum input cost, as it is producing at the output level where the MC curve is equal to the AC curve. So we can say that, perfectly competitive firms within a perfectly competitive industry are both technically and allocatively efficient.

The complete opposite to the perfectly competitive industry is the monopoly industry. In a monopoly there is only one firm. The firm in essence is the industry. The firm is the only seller in the industry and hence is the price maker. Barriers to entry exist. The Supernormal profits are available in the long run. There are no substitutes of goods. There are few different reasons why a monopoly exists. If one firm has the control of all inputs necessary to make a product then it has the potential, with the right management, to monopolise the industry for that good, as no one else is able to make the goods. If the government gives a licence to one supplier to make a certain good then the government has created a monopoly, as it only gives one firm the right to produce the good. A monopoly can occur naturally. Certain industries like the water industry, due to size and scale of them, have declining average total cost curves, so if the industry would not be producing efficiently if there were more firms in it as operating costs would be too high. The average revenue curve of a monopoly is downward sloping. It means that if the monopoly firm wants to increase sales, it must bid down the price of all the other previous units. The marginal revenue curve of the monopolist is also downward sloping, but is twice as steep as the average revenue curve. There are still some similarities between the monopoly and the perfectly competitive industry. Perfect knowledge exists and the monopoly produces at the profit maximising level of output, where MR=MC. The above information can be shown on the diagram below.

Price

MC

P*M AC

SP

C*M

Q* MR AR Output

The diagram above shows the monopoly diagram. It shows that the monopoly produces at the profit maximising level of output Q*. The diagram also shows that the firm charges at the price level P*M. The supernormal profit of the firm is the difference between the price level P*M and the cost C*M, multiplied by the output quantity Q* and is the area SP. The diagram also shows that the monopoly is being inefficient. The monopoly is not producing at the lowest point on its AC curve, so it is being allocatively inefficient. The monopoly is technically inefficient as well. Its not producing at a level where MC=AC=AR, thus not getting maximum output from minimum input. So with the diagrams, we can say that perfect competition is more efficient than a monopoly. Perfect competition is technically and allocatively efficient. A monopoly isn’t. Another reason why perfect competition is more efficient than a monopoly is due to externalities. In perfect competition society’s costs where AC=MC is equated with society’s benefits where AR=MR. In perfect competition the each firm produces the socially efficient level of output. Business practice will tell us that competition is healthy and promotes efficiency. If you have no one else in the industry, you can’t benefit from the external economies of scale of other firms in the industry. The monopoly can’t benefit from seeing other firms mistakes, which it can avoid, and the monopoly can’t benefit from seeing other firms’ good ideas, which it can copy. Without any benchmarks inefficiency’s will almost always set in.

However it can be argued that in certain ways monopolies can be more efficient than perfect competition. Monopolies can benefit from economies of size that perfect competition can’t. By being bigger monopolies can reduce average costs, by spreading costs over a larger output. Certain industries like the water industry is a natural monopoly because the costs of start up and running would be so large that having any other form of market structure would have such high costs per firm that water would be provided at a really high price and would be allocatively inefficient. The ability for monopoly’s to retain supernormal profits means that they are able to undertake research and development. The importance of research and development shouldn’t be underestimated as a major breakthrough can lead to more efficient techniques in producing capital and consumer goods. On balance it seems that perfect competition is more efficient than a monopoly.

This essay has looked at the structure of both a perfectly competitive firm and a monopoly. We have looked how each of these firms chooses to produce at their output level and price of the good they have produced. We have found out that the perfectly competitive firms are technically and allocatively efficient whereas the monopoly is not. Also discovered was that the perfectly competitive firm produces at the socially efficient level of output but the monopoly does not. However we have found out that the monopoly industry can be efficient by benefiting from economies of size and possible research and developments. So in conclusion the most efficient industry out of perfect competition and monopoly will be the one who’s benefits are greatest.