The classic problem of monopoly is that it sets a higher price than marginal cost, which distorts the trade-offs in the economy and moves it away from Pareto efficiency. We will discuss this problem here. However, other problems with monopoly may be more important. For example, the fact that a monopoly does not face the discipline of competition means that the monopoly may operate inefficiently without being corrected by the marketplace.
A competitive firm confronts demand that is infinitely elastic. For example, suppose that you grow wheat. If you charge a price for your wheat that is one penny above the market price, then you will sell no wheat. Conversely, if you charge a price that is one penny below the market price, people will want to buy more wheat than you can possibly produce. An individual wheat farmer faces infinitely elastic demand. If the marginal cost of producing a bushel of wheat is $100, then the competitive price of wheat will be $100 a bushel.
Suppose that you could establish a monopoly in wheat production. Then the demand curve that you would face would be the market demand curve, which might be
Q = 10,000 - 20P
where Q is bushels of wheat and P is the price of wheat. In a competitive market, the price would be $100 a bushel, and 8000 bushels would be consumed. For a competitive firm in this market, the revenue function isR = PQ = $100Q for P less than or equal to $100, 0 otherwise.
If the competitor tries to charge a price above the competitive price, it sells no wheat.
A monopolist faces the entire demand curve. For the monopolist, revenue is given by
R = PQ = P(100,000 - 20P)
Let us look at total revenue and total cost for various prices charged by the monopolist.
Which price should the monopolist pick in order to maximize profits?
How much do consumers lose in moving from a competitive price to a monopoly price?
At the competitive price, consumers earn a surplus equal to one half times Q times the difference betwen P and the point at which P chokes off demand, which is when P = $500. The difference between $500 and the competitive price of $100 is $400. So we have (1/2)(8000)($400) = $1.6 million in consumers' surplus at the competitive price.
At the monopoly price of $300, the difference with the choke-off price is only $200, and consumers only buy 4000 bushels. So consumers' surplus is (1/2)(4000)($200) = $400,000.
Now, we can do a complete accounting of what happens when we go from competition to monopoly. The consumers' surplus falls by $1.2 million. Producer profits rise from zero to $800,000. What happens to the remaining $400,000 of consumers' surplus that is not transferred to consumers? The remaining $400,000 is lost to the economy completely. It is the "deadweight loss" from the monopoly.
Note that if the industry were competitive and the government imposed a $200 per-bushel tax on wheat, the result for the consumer would be the same. There is the same "deadweight loss" for the economy. The only difference between a government tax and the monopoly "tax" is that the "profits" accrue to the government.
There is a disconnect between the public perception of the problem of monopoly and economists' perception of the problem of monopoly. To the public, the profits of monopolists are a measure of the problem. To economists, it is only the "deadweight loss" that matters. The profits of the monopolist represent a transfer of income, not a loss of of income. Economists cannot say whether or not a transfer of income is socially desirable. What if the monopolist were owned by sweet little old ladies and the consumers were a bunch of rich cads?