How can the abuses of monopoly power lead to market failure?

Question

I know that the abuses of monopoly power can cause market failure, but I don't know why that is. I am guessing that because monopolies face a lack of competition, they have no incentive to improve their product or service, therefore they are not allocating resources efficiently (market failure); however, in my book, a lack of competition is a separate cause, so I was wondering if there was anything else to it.

P.S. If you could include a logical chain of reasoning and an example in your answer, that would really help me to understand it. I am also revising for GCSEs so the answer need to be extremely advanced.

Answer 1

First, let's be clear what we mean by abuse of dominance: this is when a firm is a monopoly or near-monopoly, and attempts to use that position in order to perpetuate or enhance its dominance of the market at the expense of competition.

So we need to know: why would a market with a monopoly perform worse than one with competition. Here are the main typical answers:

1. A monopoly will increase the price above marginal cost by artificially constraining supply. This means that some units that consumers' value above the cost of production don't get traded, resulting in the usual dead weight loss triangle.

2. Some people speculate that a monopolist has less incentive to innovate (create new products or means of production) than a competitive firm because there is no competitive pressure to be more efficient or to have a better product than other firms. Others, though, have argued that monopolists have a larger incentive to innovate because they can capture more of the gains from invention. This is the subject of a classic debate between Arrow and Schumpeter. The empirical evidence on whether competition is good or bad for innovation is extremely mixed.

3. Rent-seeking is a concern. If a monopoly makes profit $\pi_m$ and a competitive firm makes profit $\pi_c<\pi_m$ then a firm would be willing to spend $\pi_m-\pi_c$ to become (or remain a monopoly). This is fine if the resources are spend on something socially constructive. But not if it is spent on wasteful advertising, lobbying, engineering products with poor compatibility, creating needless switching costs, etc.

4. Another concern is managerial slack / x-inefficiency. If a firm has no competitors then there is very little incentive to exert effort to become more efficient, meaning that the firm may end up spending more resources on production than necessary.

If you want to read more about these things, I would recommend the first couple of chapters of Motta's book on competition policy.

Answer 2

A market failure is when some economic structure prevents the market from achieving optimal efficiency. A critical part of how the market tends toward its optimal efficiency is via competition.

If there is no situation where more than one company could be profitable, you would have a monopoly but it wouldn't be a market failure, since that's the best you could do. Its entirely possible that this situation doesn't really exist.

If there's a situation where more than one company can be profitable, but that monopoly either has a government grant or uses violent coercion to keep its monopoly position, that is a case of government failure, since a government is either directly (with a grant) or indirectly (by failing to prevent violence) causing the monopoly.

Then you have situations where you have a structural, or natural monopoly, where every additional customer either reduces the cost of production or increases the value of the product (network effects). In certain cases, it may be unfeasible for another company to compete because the risk of failure is too high in comparison to the potential reward of success. For example, if you build a network of railroads in an area, the cost of building a new network might exceed the profits that company could expect to make. The monopoly could refuse to allow competitors to connect to its network, keeping its monopoly rents for itself. But if the situation were restructured where the monopoly was required to allow 3rd party connections, or if trains were operated only by companies that didn't own tracks, additional competition could improve the market. Since that almost never happens, a monopoly puts an opportunity cost on potential competitors, keeping them out of the market. This opportunity cost is in essence a negative externality, which is an obvious market failure.

The usual alleged market failure often associated with monopolies is the deadweight loss triangle that Ubiquitous mentioned. The idea is that the monopoly will set a price that's too high, such that the market loses out on some beneficial trades. But, it's been shown that practice of price discrimination (which is widespread in reality) eliminates this dead weight loss. More information on that can be found here: https://www.independent.org/pdf/tir/tir_10_3_02_shmanske.pdf

I wrote an article on market failure that included some analysis of monopolies: https://governology.substack.com/p/the-role-of-government-part-1