3.1.1 Allocative efficiency

To achieve allocative efficiency, prices must reflect cost conditions and thus, on the margin, production and consumption decisions must equalize the relevant marginal rate of substitution to the market price.

Case A

The first form of “allocative inefficiency” may particularly arise in small countries where, it is often argued, small markets are less competitive. This issue is considered in an empirical study of the size distribution of establishments for thirteen retail trade industries across 225 US cities by Campbell and Hopenhayn (2002).[14] In this analysis, the authors empirically compare two approaches to modelling competition among large numbers of producers. According to the first approach, a producer’s actions (eg, competitive responses) have a broad effect across the market and affect all rivals symmetrically. According to the second approach, the effects of a producer’s actions are more localised (eg, can only be felt by rivals located nearby).

This is of interest because models of competition among differentiated products provide differing conclusions on whether the size of a market matters to its competitiveness. In particular, models of monopolistic competition (such as Dixit and Stiglitz 1977) predict that doubling the number of consumers and producers has no effect on the degree of competition. Spatial models, in contrast, (eg, Salop 1979) predict that larger markets should be more competitive.

Campbell and Hopenhayn (2002) find that establishments are larger in larger markets for six industries. The authors suggest that, in these industries, competition appears tougher in larger markets. Models of competition in which individual producers’ markups do not depend on the number of producers (eg, Dixit and Stiglitz 1977) are inconsistent with these observations. Models in which competition is tougher in larger markets can reproduce the positive effect of market size on establishments’ average size.[15] Whether there are significant elements of monopoly or oligopoly pricing will depend upon additional factors such as barriers to entry; numbers of competitors is but one determinant of market performance.

In models of monopoly or oligopoly (such as Cournot-Nash or differentiated Bertrand-Nash), a firm faces a downward sloping demand curve for its own brand (ie, its residual demand curve) that reflects the firm having power over price. The magnitude of the reduction in economic welfare resulting from this distortion is calculated using concepts of consumers’ and producers’ surplus[16] to indicate efficiency: the aggregate of which is the change in total economic welfare. In Figure 1, the change in welfare resulting from the higher price is equal to the area of trapezoid (P0P1AB).

The loss in consumers’ surplus is partially offset by the increase in the producers’ surplus equal to the area of rectangle (P0P1AC). Thus, this rectangle is the wealth transfer from consumers to producers. Using a total surplus standard that makes a neutral value judgment that each agent in the economy is equally deserving of a dollar, the net welfare loss is equal to the area of triangle (ABC). This is called the “deadweight loss.”

Harberger (1954) estimates that the total welfare loss due to market power is no larger than 0.1 percent of GNP.[17] This calculation has been criticized on the grounds that the static situation it represents does not capture the longer-term dynamic effects of competition.[18]

Figure 1 – A graphical depiction of the welfare effects of an oligopolistic or monopolistic price increase [19]

A potential counter-argument to Harberger’s estimate is provided by the theory of rent seeking.[20] It suggests that, in cases where a firm has an ability to capture an oligopoly or monopoly rent, economic agents have an incentive to compete for it. This competition can involve economically wasteful activities such as lobbying, unnecessary litigation or even crime (eg, bribery). This raises the possibility that part of the rent transfer generates a net loss in real economic resources.[21]

An additional economic cost of monopoly or oligopoly markups not explicitly captured in Figure 1 lies in the possibility that it can reduce non-price competition. The key paper on the economics of non-price competition is Stigler (1968).[22] Mussa and Rosen (1978) show that the incentive for a monopolist to restrict quality (ie, reduce it) remains even if the monopolist has the option of offering both high and low quality versions (or brands) targeted at different consumers (eg, low versus high income buyers, business versus casual vacation passengers, brand conscious versus price conscious consumers).[23]

The example of the incentive to restrict quality in Mussa and Rosen (1978) has wide application. In general, the incentive for a monopolist to provide non-price attributes is related to the marginal willingness to pay, for the marginal consumer in the case of a monopolist and for the average consumer in the case of the maximization of total welfare of the economy as a whole.[24] Empirically evaluating the value of product quality or new products is a daunting task because an increase in non-price attributes such as quality shifts the demand curve and thus economic welfare may be increased even if nominal prices are little changed (or even increased). Using “hedonic” prices to account for such empirical problems, Bils and Klenow (2002) conclude that quality growth has been an important part of recent economic progress.[25]

Finally, we note that pricing above average cost is generally driven by the objective of profit maximisation. Where (cooperative) governance is such that dividends are paid out as price discounts to stakeholders there is no rationale to price differently from average cost. If scale is important, allocative inefficiency induced by a small market may be the more important issue.