We know that market power in general leads inefficient outcomes (in terms of Pareto efficiency). This makes instinctive appeal as, for example, a powerful seller who has a lot of market power can benefit by restricting supply, single-handedly raising prices.

But I was wondering, what if there are not many consumers either and thus, there is also a lot of monopsony power?

In the extreme, how is equilibrium determined in a market with just one seller and one buyer? What are its efficiency properties.

I have a feeling it is just bargaining, and maybe related solutions like Nash bargaining solution might help. Am I right? I am not sure on the efficiency implications though.

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    $\begingroup$ Although you refer to consumers, the monopoly-monopsony situation is also exemplified by labour markets in industries with a single employer and a strongly unionized labour force. $\endgroup$ – Adam Bailey Feb 8 at 14:38

Efficiency in general means that the item being traded should be given to the party that values it the most.

In a competitive market, this means trade should continue as long as a consumer's value of a good, as captured by the demand curve, is greater than a seller's value of that good, captured by the supply curve.

In a monopoly, seller's value is captured by its marginal cost curve. But since price is greater than marginal cost in equilibrium, the units for which a consumer's value is higher that MC but lower than equilibrium price don't get traded. Hence there is inefficiency: those units of the good are not in the hands of the party (i.e. the consumers) that values them the most. The story for monopsony is similar.

In a bilateral trade setting with one seller and one buyer, we need to discuss two cases. In the first case, the traders' values are common knowledge. In this case efficiency can be attained, though price depends on the relative bargaining power of the two parties. In the second case, suppose neither trader knows the other party's value, but they do know that gains from trade are possible but not certain. Then the Myerson-Satterthwaite theorem tells us that no bilateral trading mechanism that is individually rational and incentive compatible can guarantee efficiency in the ex post sense; that is, the party with a lower value for the good being traded may end up having the good.

  • $\begingroup$ Thanks for the answer! In the 'common knowledge' case, I wanted to know what are some widely used characterisations of equilibrium, how is the equilibrium found out and any references for my reading would help! $\endgroup$ – Ishan Kashyap Hazarika Feb 8 at 20:40
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    $\begingroup$ @IshanKashyapHazarika: The common knowledge case can be modeled as a simultaneous game or a sequential-move bargaining game, if you think the two traders are non-cooperative. Alternatively, if the traders can cooperate, then a Nash bargaining problem would be the right framework. $\endgroup$ – Herr K. Feb 9 at 2:40

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