The Costs and Benefits of Monopoly

In our final talk in monopoly, we're going to discuss the costs of monopoly, but also the potential benefits.

The major costs of monopoly is that compared to competition, monopoly is inefficient. It leads to a loss in the gains from trade or a deadweight loss. Let's remind ourselves about the gains from trade under competition and then we can compare with monopoly. Here we'll simplify with a flat supply curve, a constant cost industry. In this case the total gains from trade go to consumers in this blue area right here. Now let's see what the total gains from trade or total welfare is under monopoly. We choose exactly the same demand curve and the same constant cost curve. We find the profit maximizing price and quantity in the usual way. Consumers, not surprisingly, get less under monopoly since the price is higher. Now some of what the consumers lose is transferred to the monopolist in terms of profit, and as far as an economist is concerned, at least someone is getting these gains from trade. So the transfer is neutral. What's bad however, is that total welfare falls under monopoly because no one gets this area, the deadweight loss.

These are trades that from a social point of view are beneficial. The demanders are willing to pay more than what would be the cost of producing these goods. These trades, however, don't happen. Even though they're socially beneficial they don't happen because they aren't profitable, they aren't privately beneficial. Think of a movie theater that is half empty. Surely there are some people out there who would value watching the movie at more than its marginal cost, about zero. So why doesn't the movie theater lower the price to these people? Because to do so it would have to lower the price to everyone and that would reduce total profits.

So the basic lesson is this. Consumers buy a good so long as the value to them exceeds the price. Under competition, price is equal to marginal cost, so consumers will buy every unit such that the value to them is a greater than the marginal cost. That's efficient. Under monopoly, consumers also buy so long as the value to them is greater than the price, but since price is greater than marginal cost, we get too few units produced. We get a loss in the gains from trade.

Let's remind ourselves what deadweight loss looks like in practice. GSK prices Combivir at $12.50 per pill. The marginal cost is 50 cents. The deadweight loss is the value of the trades that do not occur because price is greater than marginal cost. Some people would be willing and able to pay $10 per pill or $4, or even $1 per pill and those prices would more than cover the cost of producing those pills. But those trades don't occur because they aren't profitable to GSK. Many monopolies around the world are born of government corruption. In Indonesia, Tommy Suharto, the president's son, was given the highly profitable clove monopoly. He used the profits from that monopoly to buy Lamborghini. Not a Lamborghini -- he bought the entire company. These kinds of monopolies are unredeemed. They have costs and no social benefits at all.

Some monopolies however, do have countervailing benefits. Consider what would happen if the U.S. eliminated patents for pharmaceuticals. Competition, it's true, would drive down the price of existing drugs to marginal cost, as happens today as soon as patents expire, usually within 10 to 15 years after the drug first enters the market. But it costs about a billion dollars to bring the average new drug to market in the United States, and R&D costs are not included in marginal cost. As the saying goes, it costs about a billion dollars to create the first pill, 50 cents to create the second pill. 50 cents is the marginal cost, the cost of an additional pill, but to bring that first pill to market costs about a billion dollars. If price were quickly pushed down to marginal cost, firms would not be able to recover their R&D costs, and the result would be fewer new drugs. Once the drug is created, the patent, the monopoly, creates inefficiency, we get too few units produced. But the patent increases the incentive to produce the new drugs in the first place. So there's a trade-off. More monopoly reduces static efficiency, the quantity produced, but can increase dynamic efficiency, the incentive to do research and development.

This trade-off applies to other goods with high development cost, not just pharmaceuticals. Information goods, goods like music, movies, computer programs, new chemicals, new materials, new technologies. These typically have high development costs and low marginal cost of production. And that suggests there may be possible benefits to patent or copyright protection. More generally for these types of goods there's a policy trade-off which we always want to keep in mind. That is lower prices today may generate fewer new ideas in the future. Nobel prize winning economic historian, Douglas North, for example, has argued, "The failure to develop systematic property rights in innovation up until fairly modern times was a major source of the slow pace of technological change."

Is there a better way of navigating this trade-off? Perhaps. Suppose that the government bought up a pharmaceutical patent for its total monopoly profits and then they ripped the patent up. Competitors would enter and drive the price of the drug down to marginal cost, thus we would have static efficiency. At the same time, since the government was paying firms their monopoly profits, we would still have lots of incentive to do research and development -- dynamic efficiency. Thus we could have the best of all worlds. Of course, there may be some downsides as well. Higher taxes to pay for the patent also have their own deadweight loss, and it might be difficult to say exactly how much a patent is worth. And there could be possible corruption. Nevertheless, this is an idea we're thinking about, and perhaps worth experimenting with.

Prizes are another way of navigating the trade-off. As with patent buyouts, the idea is that a firm is offered up front its R&D costs. But the government only pays the firm if it achieves a certain goal. And if that goal is achieved, the technology goes into the public domain and could be used by anyone. SpaceShipOne, for example, won $10 million for being the first privately developed manned rocket capable of reaching space and returning in a short period of time. And prizes are being used more often. The government set up a prize for better light bulbs, for example, and that worked quite well.

There's also a third way of navigating the trade-off. You may have noticed, for example, that so far we've assumed that the monopolist must charge the same price to everyone. Is this necessarily true? In some cases, the monopolist can charge different prices to different people -- price discrimination. As we'll see in the next chapter and set of lectures, price discrimination explains a lot about how products are priced and it also has some costs and some benefits which we'll be discussing. See you then, thanks.