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Monopoly and Externalities

Although in most markets competition is superior to monopoly, when a market failure occurs, monopoly may be socially preferable to competition. For example, if pollution (a negative externality) is a byproduct of a manufacturing process, a competitive market produces more output and more pollution than would a monopoly. Whether more output and pollution are better than less of both is an empirical question. An optimally regulated market with the optimal levels of output and pollution is superior to both unregulated competition and monopoly.

We can demonstrate this tradeoff using the pollution example from Chapter 3. An industry produces automobile tires and air pollution, which is a byproduct of manufacturing and increases with output. The only way to reduce pollution is to reduce production.

A monopoly, which produces less output than a competitive market, might produce closer to the optimal combination of tires and pollution than a competitive market. If a monopoly reduces its output too much, however, society may prefer excessive pollution and many tires to less pollution and few tires.

Figure 4.1 Monopoly and Pollution

Because a firm does not have to pay the costs of the pollution, its private costs (costs of labor, capital, equipment, materials) are less than the true social costs. If the market in Figure 4.1 is a monopoly, the MCp is the marginal private cost of the monopoly. If the market is competitive, the MCp curve is the market supply curve. The marginal pollution cost curve shows the dollar value of the marginal damage (health harms, property damage, reduced agricultural output, and so forth). The MCs, which is the vertical sum of MCp and the marginal pollution cost curves, reflects the full manufacturing and pollution costs to society.

In the absence of government intervention, a competitive market ignores the pollution damage and produces where supply, MCp, equals demand, D. As Figure 4.1 shows, the market produces Qc tires at a price of pc and has marginal pollution damage of Ec.

A monopoly also ignores the pollution damages and produces where marginal revenue, MR, equals its private marginal cost of production, MCp. The monopoly sells Qm units at a price of pm and has marginal pollution damage of Em.

A competitive market produces more output at a lower price than does a monopoly. The pollution damage is greater at the competitive equilibrium, Ec, than at the monopolistic one, Em, because the competitive output (and hence amount of pollution) is greater.

In Figure 4.1, the monopoly produces even less output (and pollution) than is socially optimal when pollution is taken into account; however, it could produce the socially optimal output, Q*, at the socially optimal price, p*, if the MCs curve happened to hit the demand curve at pm. Theory alone can only say that a monopoly produces less output than a competitive market; it cannot determine if the monopoly output is larger, smaller, or equal to the optimal amount in the presence of externalities.

© 2000 Dennis W. Carlton and Jeffrey M. Perloff. Reprinted by permission.

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