Question

Example 23.3 assumed that oil was produced in a competitive market. Assuming the other conditions of the example did not change, how would optimal resource use change if all oil were owned by a single monopoly firm?

Short answer

Answer: If oil production were owned by a single monopoly firm, the optimal resource use would likely involve fewer units of production and higher prices compared to a situation in which oil production took place in a competitive market. This would result in potential deadweight losses and overall less efficient use of resources.

Step-by-step solution

Recap the competitive market situation

In Example 23.3, oil production was assumed to be in a competitive market. In a competitive market, firms maximize profits by equating their marginal costs to the market price. As a result, resources are allocated efficiently since the quantity of oil produced corresponds to the market demand at the equilibrium price.

Describe the monopoly market situation

In a monopoly, there is only one firm that sets the price and quantity of the output. A monopolist will maximize its profits by equating its marginal revenue to its marginal cost, which usually results in a higher price and lower quantity produced than in a competitive market. Due to the limited competition in the market, monopolies may not allocate resources efficiently, leading to potential deadweight losses.

Compare optimal resource use

If all oil production were owned by a single monopoly firm, the optimal resource use would change compared to a competitive market. The monopoly would maximize profits at a lower level of production output, where their marginal cost equates to the marginal revenue, resulting in a higher market price for oil. In comparison to a competitive market where resources are allocated efficiently, the monopoly firm may not utilize its resources fully to align with the market demand. Fewer units of oil would be produced, creating a deadweight loss – the difference between the socially optimal level of production and the monopolist's chosen level of output.

Conclusion

In conclusion, if all oil production were owned by a single monopoly firm, the optimal resource use would likely involve fewer units of production and higher prices compared to a situation in which oil production took place in a competitive market. Such a resource allocation under a monopoly would result in potential deadweight losses and overall, less efficient use of resources in comparison to a competitive market.

Key concepts

Competitive Market Efficiency

A competitive market boasts an efficient allocation of resources, which is a foundational concept in economics. This efficiency is achieved when goods are produced at the lowest possible cost and sold at prices that reflect their marginal costs. In such a market, the quantity of output supplied is where the demand curve intersects the supply curve, signifying market equilibrium. Here, producers strive to minimize costs and maximize profits by setting their price equal to the marginal cost, which is the cost of producing one additional unit of output.

By pricing at the marginal cost, resources are utilized to the fullest, as the amount of goods produced and sold matches consumer demand. The result is that consumer surplus—consumers' gain from purchase—and producer surplus—producers' gain from sale—are maximized. This harmonious balance is disrupted when a monopoly takes over the market, as a monopolist's motive to maximize profit does not necessarily align with the efficient allocation of resources.

Marginal Cost Pricing

Marginal cost pricing is crucial in a competitive market as it determines the level at which resources are most efficiently allocated. Simply, it is the practice of setting the price of a good to equal the additional cost of producing an extra unit of that good. When a company prices its goods based on the marginal cost, it ensures that the supply of goods is responsive to consumer demand.

In a perfectly competitive market, firms have no choice but to accept the market price, which equals the marginal cost, due to the high level of competition. When markets deviate from this norm and firms have the power to set prices above marginal costs, such as in a monopoly, inefficiencies arise. This leads to reduced output and higher prices, prompting a social loss because the prices do not reflect the true economic cost of making the goods.

Deadweight Loss

Deadweight loss represents a loss of economic efficiency when the equilibrium market outcome is not achievable or not achieved. In the context of a monopoly, deadweight loss occurs because the monopolist sets a higher price and produces less than what would be achieved in a competitive market. The result is that potential trades that could benefit both the buyer and seller do not take place.

Graphically, deadweight loss can be visualized in a supply and demand diagram as the area between the demand curve and the monopolist's marginal cost curve, from the monopolist's quantity up to the competitive quantity. This area represents trades that would have been mutually beneficial but did not occur due to the monopolist's pricing above the marginal cost. The creation of deadweight loss signifies an overall reduction in social welfare—a loss that is neither offset nor claimed by any party and simply represents foregone economic opportunity.

Monopolist Profit Maximization

Unlike competitive firms, a monopolist dominates market share and can influence market prices. A monopolist aims to maximize profits by determining the output level where marginal revenue equals marginal cost. Because monopolists face a downward-sloping demand curve, each additional unit sold reduces the price for all units sold, which implies that marginal revenue is less than the price.

As a result, to maximize profit, the monopolist produces less and charges a higher price compared to competitive firms in the market. This outcome differs from the competitive ideal where price equals marginal cost, indicating that monopolies can lead to inefficiencies in resource allocation. Consumers end up paying more while receiving less quantity and variety of goods, illustrating the trade-off of monopolist profit maximization that comes at the expense of consumer surplus and overall market efficiency.