Compare the marginal value of extra output with its cost.
A firm with sustained market power may restrict output to raise profit, leaving price above marginal cost. In a model without externalities or information gaps, demand reflects marginal social benefit and marginal cost reflects marginal social cost. If extra units would benefit society more than they cost, the restriction is allocatively inefficient. Large size alone does not prove this: costs, entry, innovation and the actual competitive constraint matter.
- Output restriction
- Market power is an ability to influence price or terms. A firm may restrict sales to support a higher price, leaving some useful extra units unproduced.
- Benchmark
- P means price and MC means the cost of one extra unit. With no other failure, price reflects the buyer's marginal benefit and MC the social cost, so P = MC identifies the efficient output in the stated model.
- The firm's choice
- Marginal revenue (MR) is the extra total revenue from selling one more unit. The firm compares MR with MC when choosing profit-maximising output, which can differ from the socially efficient quantity Q.
Evaluate a competition remedy
Entry and competition
Removing unnecessary entry barriers or preventing exclusionary conduct can make the firm face stronger competitive pressure. Investigate actual barriers and behaviour.
Price regulation
A price rule can narrow the price-cost gap, but regulators need reliable cost/quality information. An overly low price can undermine service or investment.
Scale and innovation
Large firms can have cost advantages or finance innovation. Compare the feasible cost and output consequences of intervention, not size alone.
Diagram benchmark
In this single-price model, selling more requires lowering the price, including on units already sold. Extra revenue (MR) is therefore below price. MR = MC gives the firm's quantity; use demand to find its price. P = MC instead gives the efficient quantity when there are no other failures.
Worked example: A single supplier with a constant marginal cost
Demand is P = 20 - 0.2 Q, MR = 20 - 0.4 Q and MC = $4. There are no externalities or information failures, and MC crosses MR from below.
- MR = MC gives 20 - 0.4Q = 4, so 16 = 0.4Q and Q = 40. Substituting into demand gives P = 20 - 0.2(40) = $12. This is the firm's profit-maximising choice under the stated conditions.
- For the social optimum, P = MC gives 20 - 0.2Q = 4, so Q = 80. On units between 40 and 80, buyers' willingness to pay exceeds the extra resource cost. Producing those units would add net benefit.
- The linear welfare-loss triangle is 0.5 x 40 x (12-4) = $160. It is not the entire firm profit.
- Competition policy, feasible entry or price regulation may narrow the restriction, but assess fixed costs, service quality and investment incentives before choosing a remedy.
Watch out for this
Every large firm is inefficient because it is large.
Market power and behaviour matter. Scale can lower costs; analyse the price-output decision and feasible alternatives.
Check your understanding
With no externalities or information failure, price exceeds MC at a restricted output. What makes extra output potentially beneficial?
- The firm's profit is necessarily zero.
- Consumers' marginal benefit exceeds the marginal resource cost.
- All output should be given away free.