In Chapter 10 you learned that allocative efficiency was achieved only when there were many firms (providers) in the market. You now need to consider the con- sequences for price, output and efficiency when there is only one supplier in the market.
A producer should produce at the output where marginal cost equals marginal revenue because this is the output level where profits (total revenue minus total cost) are maximized. For a monopoly producer, marginal revenue is below the demand curve. This is because a one unit increase in output increases revenue by the amount of the price of that unit (indicated by the demand curve) minus the loss in revenue on the other units caused by the associated fall in price. However if, as sometimes happens, a monopoly producer price discriminates then marginal rev- enue is the same as the demand curve. Price discrimination means offering the same product at different prices to different people. For example, railways and airlines often charge lower prices to students, young people and elderly people.
This is not an act of generosity. Quite the opposite, it is a way of maximizing profits. Parkin and colleagues note that ‘by charging the highest price for each unit of the good that each person is willing to pay, a monopoly perfectly price- discriminates and captures all the consumer surplus’. In practice, monopolies are never able to perfectly price discriminate but they can discriminate between different groups of people where each group has a different elasticity of demand.
Activity 11.1
Drawing on your own knowledge and understanding of health care, can you think of any features that are characteristic of a monopoly? You need to consider aspects such as whether alternative providers are feasible and available, and whether any barriers to entry exist to stop new providers (either individual practitioners or organizations such as hospitals).
Feedback
In some cases there are close substitutes to health care but in most cases there are probably not. For example, if someone has influenza then they could take drugs for symptomatic relief. They could alternatively just spend some time in bed until the
symptoms stop. In this case rest is a substitute for medication. However, with a disease like appendicitis there is no real substitute for surgical treatment.
Health care professionals require a licence to practise. This licence is an example of a barrier to entry in the health care market. Patents are also barriers to entry because they prevent other manufacturers from producing a particular good. Patents are very com- mon in the pharmaceutical industry. There may be examples of legal monopolies in health care in some countries as well.
Health care providers are not usually considered to be natural monopolies. It was noted in Chapter 8 that economies of scale exist only for small hospitals. It is unlikely, there- fore, that a single provider can operate at a lower cost than would be achievable by several competing providers. However, in rural areas travel to other providers may be prohibitively expensive such that the local hospital is in effect a monopoly supplier for the local population.
Activity 11.2
For many years a cervical cancer screening programme based on examining slides under a microscope has existed. In 2003 the government decided that private labora- tories should carry out the laboratory work. There were 100 laboratories competing for this business. Since there are no significant economies of scale in this work, the firms carrying it out can be described in terms of the classic perfect competition model (see Figure 11.1).
However, in 2005 it was agreed that this technology was no longer appropriate and it was decided that the manual reading of slides should be replaced by automated reading, which was found to be much more accurate. Since a patent exists on this technology and there are great economies of scale, the result will be that the (single) firm that holds the patent will provide all services. The simple monopoly model in Figure 11.2 describes the new situation.
Compare the pattern of price, cost and output in the two scenarios. Why is monopoly provision against the interest of users?
Figure 11.1 Hypothetical market for cervical screening before the introduction of new technology – a perfectly competitive market
Feedback
If we assume there are no externalities, then MC = marginal social cost (MSC) and MB
= marginal social benefit (MSB). This means that the competitive market was allocatively efficient. But with the new technology, a single provider could produce at a lower cost than multiple providers. This producer, if it was a profit maximizer, would have an incentive to produce at QM, which is below the allocatively efficient output (Q*, where MC = MB). (Remember that there is no supply curve in the case of a monopoly, since quantity and price are determined by the interaction of demand and cost func- tions.) This is against the interests of consumers because units of output where the benefit exceeds the cost (MB > MC) would not be provided.
The advantage of the new technology is that potentially we can reduce costs, increasing the supply of the service. The disadvantage is that it allows a single provider to exert monopoly power. There are steps that the government can take to make sure that monopoly power is curbed and service provision is increased:
• they could make the market contestable – offering the monopoly to the pro- vider that offered to cut prices the most; or
• they could put a ceiling on the price to bring it down to the social optimum price, P* – where there is a monopoly, a price ceiling can lead to increased output (this is unlike a price ceiling in a competitive market, which will reduce the quantity supplied).
There is a particular problem when patent protection is involved. In this case, a supplier is allowed to be the sole provider of a good because it has developed the technology itself. Without patents, suppliers would not have the incentive to develop new more efficient technologies because their competitors could adopt the new technology immediately without the expense of research and development costs. The down side of patents is that the firm is able to restrict output and raise price during the period that the patent is in operation.
QM = Monopolist’s profit-maximizing output Q* = Allocatively efficient output
Figure 11.2 Hypothetical market for cervical screening after the introduction of new technology – a monopoly market
Why are monopolies inefficient? Monopolies transform consumer surplus into producer surplus. However, the loss in consumer surplus is greater than the gain in producer surplus. Therefore, there is an overall loss to society – the deadweight loss – a measure of loss in allocative efficiency.
It is sometimes suggested that monopolies are less able to achieve technical and allocative efficiency. It is argued that their incentive to reduce cost is diminished because monopolies have very large profits already. On the other hand, the vast majority of research and development comes from very large suppliers, implying that these firms pay considerable attention to cost reduction.
You have seen that markets with many suppliers tend to be very efficient (given that certain conditions are met) but that markets with only one supplier are allocatively inefficient. So what is the situation when there are a few suppliers?
(Such a system is called an oligopoly.) Well, the decisions of suppliers become very complicated when there are only a few suppliers. This is because the decisions of any one producer in the market will have consequences for all the other firms.
Although the situation is complicated, it is safe to assume that the smaller the number of producers, the easier it is for them to restrict output and raise price, and therefore the less efficient is the market.
The factors that lead to (inefficient) monopoly power are:
• few providers;
• few close substitutes;
• barriers to entry.
The existence of professional bodies might imply that supply of these professionals is restricted and this in turn implies higher salaries than there would be if there were perfect competition – i.e. that there is allocative inefficiency.
In rural areas the scarcity of hospitals might mean that hospital services are priced artificially high. Again this is inefficient. However, monopoly pricing may not occur if providers are non-profit-making.