Question

A certain town in the Midwest obtains all of its electricity from one company, Northstar Electric. Although the company is a monopoly, it is owned by the citizens of the town, all of whom split the profits equally at the end of each year. The CEO of the company claims that because all of the profits will be given back to the citizens, it makes economic sense to charge a monopoly price for electricity. True or false? Explain.

Short answer

False. Charging a monopoly price does not make economic sense because it can lead to inefficiency and a potential reduction in overall welfare, despite the profits being distributed among the citizens.

Step-by-step solution

- Understanding Monopoly Pricing

In a monopoly, a single company controls the entire supply for a product or service. This control allows the company to set the price higher than it would be in a competitive market. This is known as monopoly pricing.

- Evaluating the CEO's claim

The CEO claims it is economical to charge a monopoly price because all profits will be equally distributed among the citizens. The logic behind this argument is that any additional earnings from the inflated prices would be returned to the customers as owners. However, this assumes that all consumers and owners are the same, which may not be the case.

- Understanding Economic efficiency

In economic sense, the best outcome is when the price equals the marginal cost, because this leads to allocative efficiency - resources are allocated in a way that maximizes the net benefit to society. When a company charges a monopoly price, it generally prices above the marginal cost, which creates a deadweight loss to society. This results in inefficient outcomes.

- Conclusion

Even though citizens receive the profits, the high monopoly price may reduce the overall welfare of the citizens as consumers, especially those who consume a large amount of electricity. Therefore, it does not make complete economic sense to charge a monopoly price.

Key concepts

Allocative Efficiency

Allocative efficiency occurs when resources are distributed in a manner that maximizes the net benefit to society. With allocative efficiency, goods and services are produced at the right quantities to match consumer preferences and willingness to pay. The ideal situation is when the price of a product equals its marginal cost – that is, the cost of producing one additional unit. This equilibrium ensures that the value consumers place on a product is exactly what it costs to produce it.

In the case of Northstar Electric, the monopoly pricing strategy may divert from allocative efficiency, since the company is likely to set prices higher than the marginal costs. This results in a misallocation of resources, as the quantity of electricity demanded at the monopoly price is lower than the efficient quantity – where price would equal marginal cost. Thus, the town's citizens may not receive the amount of electricity that would be socially optimal.

Marginal Cost

Marginal cost represents the expense of producing one additional unit of a good or service. In a competitive market, the forces of supply and demand typically push the price down to where it aligns with the marginal cost. This alignment is crucial for achieving economic efficiency. However, monopolies like Northstar Electric have the power to set prices above the marginal cost, as they face little to no competition.

Because monopolists can price their goods or services above this level, the quantity sold is less than what would be sold in a competitive market, where prices are equal to marginal costs. When marginal costs are not the benchmark for pricing, it indicates that the market structure is preventing the efficient allocation of resources, potentially leading to underproduction and associated inefficiency.

Deadweight Loss

Deadweight loss refers to the loss of economic efficiency that occurs when the equilibrium for a good or service is not achieved. This can happen through price and quantity distortions, like those caused by monopoly pricing. A monopoly sets a higher price and reduces the quantity sold, compared to a competitive market. The result is that some consumers who value the product more than its marginal cost do not purchase it due to the inflated price.

In the scenario provided, the monopoly's higher pricing means that less electricity is used than would be in a competitive market. The area between the demand curve and the supply curve (marginal cost) at the quantity sold represents the deadweight loss. This loss is a cost to society, as resources are not being used to their full potential, and some consumers are denied access to electricity at a price they would have been willing to pay.

Economic Efficiency

Economic efficiency is achieved when goods and services are distributed in a way that maximizes total surplus, which includes both consumer surplus and producer surplus. For economic efficiency to prevail, it requires both productive efficiency (goods being produced at the lowest possible cost) and allocative efficiency. In economically efficient markets, every product's price reflects its marginal cost and marginal benefit to consumers.

Applying this to Northstar Electric, despite the fact that profits are returned to the citizens, the monopoly pricing strategy may lead to a reduction in consumer surplus larger than the increase in producer surplus (monopoly profits). The imbalance caused by setting prices higher than marginal costs means that while the citizens gain as shareholders, they lose as consumers, particularly those with higher consumption rates. Thus, the operation under monopoly pricing fails to achieve true economic efficiency, as the potential benefits of distributing electricity at a lower, more competitive price are forfeited.