There are four factors that can be compared here: price, output, profit and efficiency. It is helpful for analysis if both forms of market structure are shown on the same graph, as in Figure 8.8. This gives a long-run perspective. For the sake of simplicity it is assumed that long-run marginal costs are constant. This indicates that there are constant returns to scale, so that LMC and LAC are equal. PM and QM represent the price and output of the monopolist and PC and QC represent the price and total output of the industry in perfect competition (PC). The factors listed above can now be examined in turn.
a. Price. In monopoly the price is higher than in PC.
b. Output. In monopoly the output is lower than in PC.
c. Profit. There is an element of supernormal profit in monopoly, given by the area of the rectangle BCED, although as we have just seen this is not always the case in monopoly. In perfect competition the price and long-run average cost are equal, resulting in only normal profit being made.
The fourth factor listed was efficiency. We now need to explain the difference between productive and allocative efficiency, the other type of efficiency mentioned earlier in the section on perfect competition.
1. Productive efficiency. In Figure 8.8 both the monopolist and the firm in PC are achieving productive efficiency, since they both have a constant level of LAC. However, if the monopolist has a rising LMC curve as in Figure 8.6, it will not be producing at the minimum point of its LAC curve, but at a point to the left of this. It will therefore not be achieving productive efficiency. The monopolist will be using too small a scale, and using it at less than optimal capacity.
2. Allocative efficiency. This refers to the optimal allocation of resources in the economy as a whole. In order to consider this aspect we need to introduce the concepts of consumer surplus and producer surplus. Consumer surplus represents the total amount of money that consumers are prepared to pay for a certain output over and above the amount that they have to pay for this output. It is given by the area between the demand curve and the price line. Thus in perfect competition the consumer surplus is given by the area of triangle AFD in Figure 8.8.
Producer surplus, sometimes called economic rent, represents the total amount of money that producers, meaning all factors of production, receive for selling a certain output over and above the amount that they need to receive to stay in their existing use in the long run. It is given by the area between the marginal cost curve and the price line. In the special case shown in Figure 8.8 where MC is constant, producer surplus is equal to supernormal profit. However, if the MC curve is rising and there is perfect competition, the producer surplus will not be realized in the form of supernormal profit, since this will be competed away. The surplus will instead be distributed to the other factors of production, such as labour.
In order to examine and compare the allocative efficiency of the two types of market structure we need to consider the effects on total economic welfare of a change from perfect competition to monopoly. In perfect competition, total welfare is maximized because output is such that price equals marginal cost. This condition for allocative efficiency means that total welfare cannot be increased by any reallocation of resources; any gain for producers will be more than offset by a greater loss for consumers. In monopoly, output is such that price exceeds marginal cost, meaning that consumers would value any additional output more than it would cost the monopolist to produce it. However, it would not profit the monopolist to produce the additional output because their marginal revenue would fall below marginal cost. The total welfare loss can be seen in Figure 8.8. Although producers gain a surplus of BCED, as already mentioned, the size of the consumer surplus is reduced from AFD to ACB. This means that there is an overall loss of welfare, sometimes called a deadweight loss, of CFE.
One might ask at this point what relevance the total economic welfare aspects have for managerial decision-making; after all, managers are only concerned with the welfare of the firm. The reason for their relevance is that they affect government policy. As will be seen in more detail in Chapter 12, most governments monitor monopolistic industries and take an active role in discouraging restrictive practices. The impact of such policies on firms' strategies and profits can be considerable.
So far the picture painted of monopoly is an unfavourable one. However, to present a more balanced picture, it is necessary to stress that the analysis to this point has made some important and restrictive assumptions. For one thing, economies of scale have been ignored. In some industries, as seen in Chapter 6, these are of very great importance. Therefore, in industries like public utilities a monopoly may be able to produce more output more cheaply than firms in perfect competition, since firms can avoid the wasteful duplication of infrastructure like pipelines, railway tracks and cable lines.
Another factor ignored up to this point concerns the dynamic aspects of monopoly. Dynamic aspects relate to all the factors that influence economic change and growth over time. Most economists believe that such factors, such as R&D and innovation, are much more important than efficiency as far as long-run growth in productivity and living standards is concerned. In the comparative static analysis used above it is not possible to estimate the incentive effects that monopoly may have on R&D and innovation. Since a monopoly has the ability to profit from these over the long run, it may have a greater incentive to conduct R&D and develop new products than a firm in PC, which knows that any profit from such activities will rapidly be competed away. Empirical evidence regarding these aspects is somewhat inconclusive at present.
There now follows a case study on electricity generation, which explores in particular the relationships between cost structure and market structure, along with the impact of new technology.
Case study 8.1: Electricity generation
Here and now8
Distributed power generation will end the long-distance tyranny of the grid.
For decades, control over energy has been deemed too important to be left to the markets. Politicians and officials have been dazzled by the economies of scale promised by ever bigger power plants, constructed a long way from consumers. They have put up with the low efficiency of those plants, and the environmental harm they do, because they have accepted that the generation, transmission and distribution of power must be controlled by the government or another monopoly.
Yet in the beginning things were very different. When Thomas Edison set up his first heat-and-power co-generation plant near Wall Street more than 100 years ago, he thought the best way to meet customers' needs would be to set up networks of decentralised power plants in or near homes and offices. Now, after a century that saw power stations getting ever bigger, transmission grids spreading ever wider and central planners growing ever stronger, the wheel has come full circle. The bright new hope is micropower, a word coined by Seth Dunn of the WorldWatch Institute in an excellent report.* Energy prices are increasingly dictated by markets, not monopolies, and power is increasingly generated close to the end-user rather than at distant stations. Edison's dream is being revived.
The new power plants of choice the world over are using either natural gas or renewable energy, and are smaller, nimbler, cleaner and closer to the end-user than the giants of yesteryear. That means power no longer depends on the vagaries of the grid, and is more responsive to the needs of the consumer. This is a compelling advantage in rich countries, where the digital revolution is fuelling the thirst for high-quality, reliable power that the antiquated grid seems unable to deliver. California provides the best evidence: although the utilities have not built a single power plant over the past decade, individuals and companies have added a whopping 6gW of nonutility micropower over that period, roughly the equivalent of the state's installed nuclear capacity. The argument in favour of micropower is even more persuasive in developing countries, where the grid has largely failed the poor.
This is not to say that the existing dinosaurs of power generation are about to disappear. Because the existing capital stock is often already paid for, the marginal cost of running existing power plants can be very low. That is why America's coal-fired plants, which produce over half the country's power today, will go on until the end of their useful lives, perhaps decades from now - unless governments withdraw the concessions allowing them to exceed current emissions standards.
While nobody is rushing to build new nuclear plants, old ones may have quite a lot of life left in them if they are properly run, as the success of the Three Mile Island nuclear power plant in Pennsylvania attests. After the near-catastrophic accident in 1979 that destroyed one of the plant's two reactors, the remaining one now boasts an impressive safety and financial record. Safety and financial success are intimately linked, says Corbin McNeill, chairman of Exelon and the current owner of the revived plant. He professes to be an environmentalist, and accepts that nuclear power is unlikely to be the energy of choice in the longer term: 'A hundred years from now, I have no doubt that we will get our energy using hydrogen.' But he sees nuclear energy as an essential bridge to that future, far greener than fossil fuels because it emits no carbon dioxide.
The rise of micropower does not mean that grid power is dead. On the contrary, argues CERA, a robust grid may be an important part of a micropower future. In poor countries, the grid is often so shoddy and inadequate that distributed energy could well supplant it; that would make it a truly disruptive technology. However, in rich countries, where nearly everyone has access to power, micropower is much more likely to grow alongside the grid. Not only can the owners of distributed generators tap into the grid for back-up power, but utilities can install micropower plants close to consumers to avoid grid bottlenecks.
However, a lot of work needs to be done before any of this can happen. Walt Patterson of the Royal Institute of International Affairs, a British think-tank, was one of the first to spot the trend toward micropower. He argues that advances in software and electronics hold the key to micropower, as they offer new and more flexible ways to link parts of electricity systems together. First, today's antiquated grid, designed when power flowed from big plants to distant consumers, must be upgraded to handle tomorrow's complex, multi-directional flows. Yet in many deregulated markets, including America's, grid operators have not been given adequate financial incentives to make these investments. To work effectively, micropower also needs modern command and communications software.
Another precondition is the spread of real-time electricity meters to all consumers. Consumers who prefer stable prices will be able to choose hedged contracts; others can buy and sell power, much as day traders bet on shares today. More likely, their smart micropower plants, in cahoots with hundreds of others, will automatically do it for them.
In the end, though, it will not be the technology that determines the success of distributed generation, but a change in the way that people think about electricity. CERA concludes that for distributed energy, that will mean the transition from an equipment business to a service business. Already, companies that used to do nothing but sell equipment are considering rental and leasing to make life easier for the user.
Forward-looking firms such as ABB, a Swiss-Swedish equipment supplier, are now making the shift from building centralised power plants to nurturing micropower. ABB is already working on developing 'microgrids' that can electronically link together dozens of micropower units, be they fuel cells or wind turbines.
Kurt Yeager of the Electric Power Research Institute speaks for many in the business when he sums up the prospects: 'Today's technological revolution in power is the most dramatic we have seen since Edison's day, given the spread of distributed generation, transportation using electric drives, and the convergence of electricity with gas and even telecoms. Ultimately, this century will be truly the century of electricity, with the microchip as the ultimate customer.'
*'Micropower: the next electrical era', by Seth Dunn. WorldWatch Institute, 2000.
1 Explain why power generation has traditionally been a monopoly in all developed countries.
2 What is meant by a transmission grid? How is this feature related to a monopolistic market structure?
3 What is meant by micropower? What are its implications for grid systems?
4 What are the implications of micropower for the environment?
5 How do you think changes in technology will affect the market structure of the power generation industry?
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