Is it possible that excess capacity or inefficiencies are a good thing in a monopoly? Why or why not?

1 Answer
Sep 19, 2015

Answer:

Perhaps excess capacity could lead to an increase in the monopoly quantity, which would reduce deadweight loss, the source of monopoly inefficiency.

Explanation:

I have tried to draw some illustrative graphs here.

The left-hand graph describes the deadweight loss impact of monopoly -- the real inefficiency of monopoly. The monopoly maximizes profit -- as all firms do -- by finding the quantity at which marginal revenue = marginal cost.

Unfortunately for society, a monopoly faces a downward sloping demand curve, which means the marginal revenue curve falls below the demand curve. (A perfectly competitive firm perceives a horizontal demand curve which is identical to its marginal revenue curve.) Thus, the monopoly quantity, Q(M) is less than the equilibrium quantity of a competitive market, Q(C). The deadweight loss appears as the "triangle between the demand curve and the marginal cost curve, at quantities greater than Q(M).

The right-hand graph shows the Long Run Average Cost curve, LRAC, as well as two illustrative Short Run Average Cost curves, SRAC-optimal and SRAC-excess -- and their corresponding marginal cost curves, MC-optimal and MC-excess. Clearly, I struggle drawing curvy lines! The MC curves should intersect the minima of the SRAC curves.

The point of the right-hand graph, though, is that a monopoly with excess capacity would have a marginal cost curve to the right of the optimal marginal cost curve. Since the marginal cost curve in the left-hand graph intersects marginal revenue at a quantity that is below the socially efficient Q(C), it is possible that a monopoly with excess capacity would "fool itself" into maximizing its profit at a quantity closer to Q(C).

Of course, these graphs should also illustrate that it might be possible that the excess capacity would "over-shoot", Q(C), which would lead to a different sort of inefficiency -- too much production and consumption instead of too little. I suppose that's related to the theory of second-best, but that's a more complicated topic!