Economist Writing Every Day

We are living in volatile times. With covid-19, big federal legislation packages, and the Ruso-Ukrainian conflict disruptions to grain, seed oils, and crude oil, relative prices are reflecting sudden drastic ebbs of supply and demand. I want to make a small but enlightening point that I’ve made in my classes, though I’m not sure that I’ve made it here.

Economists often get a bad rap for being heartless or unempathetic. Sometimes, they are painted as ideologues who just disguise their pre-existing opinions in painfully specific terminology and statistics. Let’s do a litmus test.

Consider two alternative markets. One is a perfect monopoly, the other has perfect competition. All details concerning marginal costs to firms and marginal benefits to consumers are the same. In an erratic world, which market structure will result in greater price volatility for consumers? Try to answer for yourself before you read below. More importantly, what’s your reasoning?

Extreme Market Power

A distinguishing difference between a competitive market and a monopoly concerns prices. While firms maximize profits in both cases, the price that consumers face in a competitive market is equal to the marginal cost that the firms face. There is no profit earned on that last unit produced. In the case of monopoly, the price is above the marginal cost. Profits can be positive or negative, but the consumer will pay a price that is greater than the cost of producing the last unit.

Below are two graphs. Given identical marginal costs of production and benefits that the consumers enjoy, we can see that:

1. The monopoly price is higher.
2. The monopoly quantity produced is lower.

But static models only go so far. What about when there is volatility in the world?

Volatile Costs

Oil and gasoline are important inputs for producing many (most?) physical goods. Not only that, they are short-lived, meaning that they disappear once they are used, making them intermediate goods. Therefore, changes in the price of oil constitutes a change in the marginal cost for many firms. If the price of oil rises, or is volatile otherwise, then which type of market will experience greater price and quantity volatility?

Below are two figures that illustrate the same change in the marginal cost. We can see that:

1. Monopoly price volatility is lower (in absolute terms and percent).
2. Monopoly quantity produced volatility is lower (in absolute terms, though no different as a percent).

The take-away: While monopoly does constrict supply and elevate prices, Monopoly also reduces price and output volatility when there are changes in the marginal cost.  

Volatile Demand

That covers the costs. But what about volatile demand? A large part of the Covid-19 recession was the huge reallocation of demand away from in-person services and to remote services and goods. What is the effect of market power when people suddenly increase or decrease their demand for goods?

Below are two figures that illustrate the same change in demand. We can see that:

1. Monopoly price volatility is higher (in absolute terms, though no different as a percent).
2. Monopoly quantity produced volatility is lower (in absolute terms, though no different as a percent).

Monopolies Don’t Cause Inflation

Economists know that inflation can’t very well be blamed on greed (does less greed beget deflation?). Another problematic story is that market concentration contributes to inflation. But the above illustrations demonstrate that this narrative is also a bit silly. Monopolistic markets cause the price level to be higher, it’s true. But inflation is the change in prices. Changing market concentration might be a long term phenomenon, but can’t explain acute price growth. If demand suddenly rises, monopolies result in no more price growth than perfectly competitive markets. If the marginal cost of production suddenly rises, monopolies result in less price growth.

All of this analysis entirely ignores welfare. Also, no market is perfectly competitive or perfectly monopolistic. They are the extreme cases and particular markets lie somewhere in between.

Did you guess or reason correctly? Many econ students have a bias that monopolies are bad. So, in any side-by-side comparison, students think that “monopolies-bad, competition-good” is a safe mantra. But the above illustrations (which can be demonstrated mathematically) reveal that economic reasoning helps to reveal truths about the world. Economists are not simply a hearty band of kool-aid drinking academics.