A monopoly is a single supplier within a market that chooses to produce at any point on the market demand curve; they appear when other firms find it unprofitable or impossible to enter a market. The market becomes affected by high barriers to entry, which are split into technical and legal barriers. Technical barriers are created when the production of a good produces decreasing marginal and average costs over a wide range of output levels; in this situation, large scale firms are low cost producers. Another technical barrier to monopolies is their ability to discover a low cost production technique and having ownership over productive resources therefore preventing the formation of other firms. Legal barriers occur when a monopoly is created by the government as a matter of law, there is the creation of a patent that allows the one firm to use the basic technology for a product.
Varian describes how monopolies arise within his writings, he states that monopolies develop when the minimum efficient scale is large relative to the size of the market, then the industry becomes a candidate for regulation or other forms of government intervention. A second way a monopoly may arise is when a number of different firms in an industry collude and restrict output in order to raise prices and therefore increase their profits. This form of industry is referred to as a cartel (Varian, 1996, p.418-419). From this we can see that if demand is large relative to the MES (minimum efficient scale) a competitive market will arise, if it is small, a monopoly structure is possible. This is influences by both the technological level and economic policy influencing the size of the market.
Before we analyse the efficiency of monopolies in comparison to perfect competition, it is necessary to set the basis of measurement for both the monopolies and perfectly competitive firms. This is set out in the First Theorem of Welfare Economics; which explains the relationship between perfect competition and the efficient allocation of resources. Attaining a Pareto efficient allocation of resources requires that the rate of trade off between any two goods should be the same for all economic agents. In a perfectly competitive economy, the ratio of the price of one good to another provides the common rate of trade off to which all agents will adjust. Because all agents face the same prices, all trade off rates will be equalised and an efficient allocation will be achieved (Snyder and Nicholson, 2005, p.471). Varian however states that the First Theorem of Welfare Economics says nothing about the distribution of economic benefits; market equilibrium might not be a “just” allocation (Varian, 1996, p.510-511). Therefore in essence the Theorem states that a competitive economy is efficient, if a monopolist behaves non-competitively then he is behaving inefficiently.
It is seen that monopolies create a Pareto inefficient level of production, relative to perfect competition;...