What this lesson teaches
I can explain the causes of market failure: public goods, externalities, information failure, immobile factors and market dominance.
Syllabus 9570, 2.3.2(b). Market Failure and its Causes: Markets may fail in terms of; non-provision of public goods due to non-rivalry and non- excludability; non-socially optimal levels of goods and services due to the presence of externalities, information failure (including asymmetric information), immobility of factors of production, and market dominance
Make a guess
A dominant firm sells 40 units at $12. Each unit costs $4 to make, and buyers would take 80 units at $4. Is output efficient?
- Yes, because buyers freely choose to pay $12 for it.
- No. Units buyers value above $4 go unmade.
- Yes, because the firm maximises its profit.
Show the answer
No. Units buyers value above $4 go unmade.
Price above marginal cost means society would gain from more output. The dominant firm restricts output to keep its price high.
A dominant firm restricts output to raise its price, so less is produced than society wants.
A firm with market power maximises profit where MR = MC. Because it must lower its price to sell more, MR is below price, so it stops at a lower output than the efficient level.
Without externalities, the efficient output is where price (reflecting marginal benefit) equals marginal cost.
At the dominant firm's output, the price is above MC: consumers would value extra units more than they cost to produce, but they are not made. This is a deadweight loss.
Singapore's Competition and Consumer Commission (CCCS) investigates abuse of market dominance and blocks mergers that would substantially reduce competition.
Some industries are natural monopolies: one network of pipes or cables can serve the whole market at a lower average cost than two could, so breaking up the firm would raise costs. For these, governments regulate the price instead. Setting price equal to MC gives the efficient output, but because AC is still falling, MC is below AC and the firm makes a loss that must be subsidised.
A common compromise is average-cost pricing: the regulator sets price equal to AC. The firm earns only normal profit, output is much closer to the efficient level, and no subsidy is needed. The risk is that a firm whose costs are always covered has little reason to cut them.
The other option is public ownership, or nationalisation, so that prices can be set for society's benefit rather than for profit. In Singapore, the national water agency PUB, a statutory board, supplies water, while the Energy Market Authority regulates the charges for using the electricity grid.
- Output
- MR = MC, below the efficient level.
- Price
- Above MC.
- Result
- Deadweight loss.
- Natural monopoly
- MC pricing needs a subsidy; AC pricing gives normal profit and more output.
Worked example: A single supplier
Suppose a dominant supplier's MR = MC at 40 units, where it charges $12. Marginal cost is a constant $4, and buyers would take 80 units at $4.
- The firm produces 40 units and charges $12.
- Efficient output is 80 units, where price equals MC.
- The 40 units not produced were worth more to buyers than their $4 cost.
- Deadweight loss = 1/2 x 40 x ($12 - $4) = $160.
Watch out for this
A dominant firm is always inefficient in every way.
It restricts output (allocative inefficiency), but it may have lower costs from economies of scale or fund innovation. Judge each effect.
Check your understanding
Why does a dominant firm produce less than the efficient quantity?
- Demand for its product is low, so it cannot sell more.
- Its costs rise steeply, so producing more would mean a loss.
- It maximises profit where MR = MC, and MR is below price.
Show the answer
It maximises profit where MR = MC, and MR is below price.
Right. It stops before price falls to MC.