Monopoly and monopsony represent two extreme forms of market power, providing insight into how a single participant—either a seller or buyer—can influence prices. In a monopoly, one seller dominates the market, setting prices above competitive levels. Conversely, a monopsony occurs when there is only one buyer, influencing the prices it pays to suppliers. Both forms impact market efficiency, producer and consumer surplus, and social welfare.
Monopoly: The Single Seller
In a monopoly, the firm is the sole producer of a good or service, facing the entire market demand curve. This allows the monopolist to determine the quantity to produce, with the corresponding price derived from the demand curve. Monopolists aim to maximize profits by choosing the quantity where marginal revenue (MR) equals marginal cost (MC).
Marginal Revenue and Price Relationship
The price set by a monopolist exceeds marginal cost because increasing sales requires lowering prices on all units, not just the additional ones. The relationship between marginal revenue and price can be written as:
$$
MR = P + \frac{dP}{dQ} \cdot Q
$$
This equation shows that marginal revenue is lower than price when the demand curve slopes downward.
Profit Maximization in Monopoly
The monopolist maximizes profit by setting output where marginal cost equals marginal revenue:
$$
MR = MC
$$
At this optimal output, the price charged will be higher than in a competitive market, resulting in higher profits but lower quantities sold. This pricing strategy imposes a deadweight loss on society because some consumers who would purchase at competitive prices are excluded.
Monopsony: The Single Buyer
In a monopsony, a single buyer controls the market, setting prices lower than in a competitive market. A monopsonist maximizes its net benefit by choosing the quantity where the marginal value of the good equals the marginal expenditure required to purchase it. The key condition for a monopsonist is:
$$
MV = ME
$$
where (MV) is the marginal value of the good, and (ME) is the marginal expenditure on additional units.
Price Discrimination and Market Power
Both monopolists and monopsonists can engage in price discrimination to capture surplus. Monopolists may charge different prices to maximize profits, while monopsonists may vary the prices they pay to minimize costs.
Social Costs and Inefficiency
Market power creates inefficiencies by reducing the quantity exchanged compared to a competitive market. The social cost of monopoly or monopsony power is represented by the deadweight loss, calculated as the lost surplus from transactions that no longer occur.
For monopolies, the deadweight loss is:
$$
\text{Deadweight Loss} = \frac{1}{2} (P_m – P_c) (Q_c – Q_m)
$$
where (P_m) and (Q_m) are the monopoly price and quantity, and (P_c) and (Q_c) are the competitive price and quantity.
Regulation and Market Efficiency
Government intervention, such as price regulation, can mitigate the negative effects of monopoly power. A regulated monopoly may be required to set prices where:
$$
P = MC
$$
This ensures that the price reflects the marginal cost, eliminating deadweight loss and improving social welfare.
Conclusion
Monopolies and monopsonies illustrate the significant impact of market power on prices, production, and welfare. While firms with market power benefit from higher profits, consumers and society often bear the cost. Regulation and competition policies aim to reduce these inefficiencies, promoting fair prices and efficient markets.