It is said in the textbook "Intermediate Microeconomics a Modern Approach" by Hal Varian that monopoly affects the informational role of price. What's the mechanism?
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2 Answers
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A foundational result from models of perfect competition is that the competitive market equilibrium (i.e. setting price and quantity such that supply = demand) is efficient. By efficiency we mean that the sum of consumer surplus and producer surplus are maximised.
This is actually quite an amazing thing! It means that each individual consumer buys the good if and only if the welfare he receives from doing so is greater than the marginal cost of producing the good. To see that this must be true, suppose that there were a consumer who values a good at more than the cost of production but did not buy it. Then it would be possible to increase welfare by having the consumer buy the good, contradicting the result that the equilibrium is optimal. Similarly, efficiency demands that sellers produce exactly as much as is necessary to sell to the consumers who will ultimately buy.
How could we get to this efficient point? One way would be to have economists calculate what is efficient and then publish this information so that people could look-up whether they are supposed to buy/sell or not. But wait! We know that there aren't economists running round telling consumers whether it would be efficient for them to buy or not. So how do people figure this out for themselves?!
The answer is that the equilibrium price contains all of the information that they need to figure out what is efficient. Since the equilibrium price is equal to marginal cost, and since consumers will buy if their willingness to pay is above the price, a consumer wishes to purchase if amd only if his willngness to pay is bigger than the cost—i.e. exactly when it is efficient for him to do so. Thus, one way to think about the role of a price in a competitive market is that it transmits information to market participants about the efficiency of a trade they are contemplating.
For a monopoly things are different because the monopolist breaks the direct relationship between price and marginal cost by setting $p>MC$. This means that some consumers who have a willingness to pay that satisfied $p>WTP>MC$. The fact that $p>WTP$ means the price is signalling to these consumers that they should not buy, even though it would be efficient for them to do so (because $WTP>MC$). In other words, the price is no longer directly informative about the efficiency of a trade, so one way to think about the effect of monopoly on prices is that it reduces their information content.
ADDENDUM:
It's still possible to calculate cost—and hence the efficient allocation—from the monopoly price, but we need more information. In particular, the monopoly price satisfies $$\frac{p-c}{p}=-\frac{1}{\eta},$$ where $\eta$ is the price elasticity of demand and $c$ is marginal cost. Thus, to figure out marginal cost we need know the price and the elasticity, whereas in a competitive market we only needed to observe the price.
answered Nov 28, 2015 at 20:30
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$\begingroup$ Thanks for answering and your answer is great. But there is one thing I cannot fully understand: what did you mean by " It means that each individual consumer buys the good if and only if the welfare he receives from doing so is greater than the marginal cost of producing the good. " Can I interpret it as " the consumers produce goods themselves as well as buy from others, when the MC of producing is lower than the welfare they receive from the good, they will buy from others", well that doesn't make any sense. Or you mean " as MC=P, when MU(marginal utility)>MC=P, the consumer will buy" $\endgroup$– GulooCommented Nov 29, 2015 at 1:52
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$\begingroup$ @Guloo I meant when MU>MC=P, the consumer will buy. The reason I didn't write it that way is that the consumer's decision rule isn't exactly to check whether MU>p. He also needs to check whether there is another good he could spend his money on that would be even better for him. So a true measure of his benefit from buying must account for the opportunity cost of not consuming something else (sometimes called the marginal utility of income). But when one does account for this, the intuition remains broadly the same, so it's okay for you to think using the heuristic MU>MC=P rule. $\endgroup$ Commented Nov 29, 2015 at 9:54
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$\begingroup$ Thanks, the answer is helpful. However the MC confuses me, so I want to make sure I get your point. Did you mean that the MC is the consumer's marginal cost (like opportunity cost), not the producer's? $\endgroup$– GulooCommented Nov 29, 2015 at 11:02
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$\begingroup$ @Guloo No, the MC is the producer's (firm's) marginal cost. This is why the informational role of prices is so important. The consumer has no (direct) to know how much it costs the firm to produce a unit of the good. But in a competitive market he doesn't need to know because this information is contained within the price. $\endgroup$ Commented Nov 29, 2015 at 12:03
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$\begingroup$ Is this the only information that price provides ? I mean just the technical efficiency of a transaction. $\endgroup$ Commented Nov 29, 2015 at 12:52
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Price acts as a signal in markets. In a perfectly competitive market all firms face a horizontal demand that is fixed by the market and hence they have no control over the price of their good. It is market determined and no single firm can influence it. However, in an monopolistic market where there are many brands they have some control over their prices. Each brand can have a differentiating feature and certain level of loyalty. Imagine a firm whose brand is very strong, it can certainly charge a higher price. In fact informed buyers in general will expect strong brands to charge a higher price than others. Others might be offering cheap goods so and they will have their own market share. Hence the price change here is like a signalling event which can give information to buyers whether the goods are of good quality or substandard etc. Now, imagine a monopoly. In a perfect monopoly price will give no information. There is a single firm which produces goods and it can decide any quantity and price suiting it cost structure. A monopoly charging very high price doesn't mean it will offer high quality goods.
answered Nov 28, 2015 at 17:12