15 - Market Failures: Monopolies

Abstract

Government regulation of monopolies is necessary because monopoly pricing and production practices reduce social welfare. The monopolist produces little total output, causing a loss in the net benefits from production. The government uses a variety of tools to influence monopoly production. Subsidies can be used to increase monopoly output, as can the use of price discrimination. More used is the government's power to regulate production directly or to break up monopolies into competitive firms. The threat of government action is enough to make monopoly firms act like competitors and increase output. The current loss from monopoly power is small because of the success of governmental actions in this area. Monopolies might be undesirable, but trade-offs are also present. The monopoly might generate external benefits in terms of innovation, new knowledge, and new inventions. These external benefits might balance the costs that monopolies impose. Government patents and copyright laws encourage the limited formation of monopolies to encourage the production of these external benefits. A natural monopoly exists when average costs are greater than marginal costs at levels of output consistent with competition. Many competitive firms would go out of business under these conditions. Monopoly is the only form of market organization that can survive in these markets. Natural monopolies produce benefits by their existence; however, lower social welfare when they pursue monopoly pricing practices. Society is best off when marginal cost pricing is used by natural monopolies, but a way has to be found to finance the deficit that results.