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Unformatted text preview: analysis. To see whether this statement holds in general equilibrium, we will need to investigate whether the monopoly creates any departure from the usual Pareto optimal conditions of an economy under perfect competitive forces. For example, consider an economy of two sectors with different market structures as follows: 273  Monopoly in sector X Sector X has a monopolist operating according to the profit maximization rule MRX = MCX  Perfect Competition in sector Y Sector Y has competitive firms operating according to the zero profit condition PY = MCY The factor markets for capital and labour are still under perfect competition, and hence, we can still pick a point on the production possibility frontier of the economy. In terms of consumption, we have the following marginal rate of substitution: MRS = PX PY On the other hand, in terms of production, we have the following marginal rate of transformation: MRT = MCX MCY MRT = MCX PY And since MRX = MCX in equilibrium... MRT = MRX PY Applying the relationship between marginal revenue and market price calculation that we did previously (i.e. MCX = PX [ 1 1/]), we get MRT = PX [ 1 1/] PY MRT = PX [ 1 1/] PY MRT = MRS [ 1 1/] 274 The presence of the price elasticity of demand creates a discrepancy between the marginal rate of substitution on the consumption side and the marginal rate of transformation on the production side MRS MRT This departure from the usual Pareto optimal conditions indicates the lack of Pareto efficiency under monopoly. In other words, the result Monopoly is less efficient than Perfect Competition. still holds in general equilibrium! THEORY OF SECOND BEST The theory of Second Best studies the welfare effects of an economy having various institutional constraints such as market imperfections, government policies and regulations. These institutional constraints result in a departure from the usual optimal marginal cost pricing rule P = MC For example, market imperfection (such as a monopoly) and market interventions through policy and regulation (such as a tax or subsidy) create a divide between the price and the marginal cost Monopoly Tax Subsidy MR = MC (1 t)P = MC (1 + s)P = MC => => => P MC P MC P MC In general, these institutional constraints can be represented by an appropriate scale factor in the marginal cost pricing rule as follo...
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