This week in my ECONS102 class, we will be covering monopoly. One aspect of that topic is a consideration of public policy that can be applied to reduce the deadweight loss of monopoly. A deadweight loss is a loss of total welfare, and this is important because total welfare is our measure of how much net benefit is generated by the operations of a market. In the simplest sense, total welfare is made up of the consumer surplus (the gains for buyers of participating in the market) and producer surplus (the gains for sellers of participating in the market - essentially, their profits). If a monopoly creates a deadweight loss, then that means that the market isn't generating as much total welfare as it could.
A monopoly creates a deadweight loss because in its efforts to maximise profits, it restricts the quantity that it sells below the welfare-maximising quantity. This is illustrated in the diagram below (which uses a constant-cost monopoly as a simplifying example). The monopoly operates at the profit-maximising quantity, which is where marginal revenue meets marginal cost, at the quantity QM. To sell that quantity, the monopoly would want to set the price at PM (since at PM, the quantity demanded is exactly equal to QM). At that price and quantity, the consumer surplus is equal to the area ABPM, the producer surplus is equal to the area PMBDP0, and total welfare is equal to the area ABDP0.
However, if this market was perfectly competitive, it would operate at the quantity where supply meets demand, which is Q0. The equilibrium price would be P0. Consumer surplus would be equal to the area ACP0, producer surplus would be zero (because every unit costs P0 to produce, and that is equal to the selling price), and total welfare would be ACP0. This total welfare is maximised (because the quantity Q0 is the quantity where marginal social benefit is equal to marginal social cost, which is the required condition for maximising total welfare). Total welfare is lower for the monopoly firm by the area BCD, which is the deadweight loss of the monopoly.
Anyway, coming back to policy, one of the options available to the government is to restrict monopoly's market power by preventing monopolies from forming in the first place. After all, one way that we get large firms like monopolies is when two or more moderately-sized firms merge together. So, government can use anti-trust legislation to prevent these mergers and reduce the deadweight loss of monopoly. No monopoly means no deadweight loss (or, more likely, more competition means something that is closer to perfect competition than to monopoly, and higher total welfare). So, increasing competition seems like a good thing.
Which brings me to this example, from the New Zealand Herald back in February:
Trade Me has applied to the Commerce Commission for clearance to buy property business homes.co.nz.
The Commission said it got a clearance application from Trade Me Limited to buy 100 per cent of the shares or assets of PropertyNZ, which owns and operates the homes.co.nz website...
A public version of the clearance application will be available shortly on the Commission's case register.
The commission says it will give clearance to a proposed merger if it's satisfied it won't substantially lessen competition.
The wording "substantially lessening competition" comes from Section 27 of the Commerce Act, which is the legislation that the Commerce Commission exists to enforce (among other things). However, I think that wording is problematic, because lessening competition is not necessarily the same as decreasing total welfare. In fact, it is entirely possible for a merger between two firms to increase total welfare, while at the same time substantially lessening competition. [*]
To see how, consider the diagram below. Initially, there are many firms in perfect competition, operating at the quantity where supply meets demand, which is Q0. Total welfare is equal to the area ACP0 (this is the same as the previous diagram above). However, when the firms merge to form a single monopoly producer, there are cost savings. Perhaps the single firm doesn't need as many back office functions like finance or HR, and can consolidate some functions. This is represented by the lower marginal cost line MSC'. The merged firm is going to profit maximise by operating at the quantity where marginal revenue equals marginal cost, which is Q1, with a price of P1. The price is higher than the many perfectly competitive firms were charging. Consumer surplus falls to the area AEP1, so consumers are worse off. Producer surplus increases to the area P1EFG, which is much larger than zero (which is why the firms want to merge, no doubt). Total welfare is now the area AEFG.
Has total welfare increased? That depends. The area ECH was part of total welfare under perfect competition, but has been lost in the merger. However, the merger leads to a gain of total welfare equal to the area P0HFG. The question is, which of those two areas (ECH or P0HFG) is larger? It is entirely possible that P0HFG could be larger, in which case the merger increases total welfare (and therefore makes society better off in total). That would require your anti-trust authority to estimate the gains and losses of total welfare arising from the merger and compare them. But, if your test is whether the merger lessens competition (as is the rule applied by the Commerce Commission in New Zealand), even if total welfare increases, the merger could still be declined.
Of course, in practice the word 'substantially' becomes key in the Commerce Commission's assessment of merger applications, because all mergers must lessen competition to some extent. It seems to me, though, that the test potentially excludes some welfare-increasing mergers. A more suitable test is whether the merger reduces total welfare.
[HT: One of our tutors from last year, Taylor, who alerted me to the difference between the theoretical welfare test, and the test that the Commerce Commission actually applies]
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[*] Note that I am not saying that this necessarily applies to the TradeMe and PropertyNZ application.
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