Imperfect Competition:

Imperfect competition  is  one  of the  standard  examples of market  failure, which  leads to the non-achievement  of Pareto  optimality.  It  is on  this basis that economic policy is usually suggested as necessary to reduce in efficiency. Forms of imperfect competition  include:

•  Monopoly, in which there is only one seller of a good.
•  Oligopoly, in which there is a small number of sellers.
•  Monopolistic competition,  in  which  there are  many  sellers  producing highly, differentiated goods.  
•  Monopsony, in which there is only one buyer of a good.
•  Oligopsony, in which there'is a small number of buyers.

There may also be imperfect competition  in markets due to buyers or sellers who lack information about prices and the goods being traded. There may also be  imperfect competition due  to a time lag  in  a market. For example, in the 1990s, there was a shortage of computer programmers as becoming a skilled programmer requires several years of experience the  shortage of such skilled personnel continued. Another example  is  the "jobless recovery". There are many growth opportunities available  afier  a recession, but it takes time for employers  to react, which would result  in  gainful employment. Hence high unemployment persists.

To demonstrate that imperfect competition fails to generate a Pareto optimum, it  is necessary  to  provide a suitable characterisation  of  Pareto optimality.

There  are several ways  in which  this can be  done. First, by consideration of the competitive equilibrium it can be  appreciated that competitive firms price at marginal cost which  is  one  of  the  conditions for  Pareto optimality.  In contrast, price will  not  be  equal to marginal  cost  in  the  imperfectly competitive industry. A second method of comparison is that  at  a  Pareto  optimum,  the  ratio  of shadow prices for any pair of goods is equal to the ratio of market prices. But for  the economy with imperfect competition, assuming  that  there  is a single firm  in  each imperfectly competitive industry, prices  are not  proportional to the marginal rates of transformation, which captures the social cost  of producing each good.  In addition, the  imperfectly competitive firms take the effects of their actions upon prices into account, which eliminates  the  direct proportionality.

The  imperfectly competitive equilibrium cannot maximise the value  of any social welfare function that satisfies the  Pareto criterion. This  observation then makes it natural to consider what the degree of welfare loss may actually be,  either for a  real  economy or  for simulated examples. The assessment of monopoly welfare loss has  been  a subject of  some dispute  in  which calculations have  provided  a range of estimates  from  the effectively insignificant to considerable percentage of potential welfare.

That monopoly causes loss of welfare and misallocation of resources will become clear by considering the following Figure. It will be seen from the figure that the transformation curve of the community AB  is  tangent  to the community indifference curve IC₃ at point E. Therefore, at point E MRT_xy of the community is equal to the MRS_xy,  Thus, E represents maximum possible  level  of  social welfare and  the  combination  of  two commodities being produced represents optimum allocation of resources. But
when the commodity X is being produced under conditions of monopoly, the equilibrium will be at H, not at E .

This  is because, under monopoly, producers would be  equating MRT or  the ratio  of marginal costs with  the  ratio of marginal revenues and not with the ratio of prices of two goods. Since consumers would be  equating MRS with the price ratio of two goods, the MRT  in  the equilibrium position at point H will not be equal to the MRS. This is quite obvious from the figure where at

point H transformation curve AB  and consumers indifference curve IC₁ are intersecting. This implies that the slopes of transformation curve at point H, which  indicates MRT  and  the slopes of  consumer's indifference curve IC₂, which indicates MRS,  will  not  be  the same.  It will  be  observed  from  the figure that  at point H, MRS  is greater  than MRT_xy  as tangent ll'  drawn to point  H on  IC₁  is  steeper than the tangent  kk' drawn  to  point  H on  the transformation curve AB. This means that consumers' preference is that good X should be  produced more but because of the existence of monopoly in  the production of commodity X,  it  is not  being  produced to the desired quantity.

As a result, the level of satisfaction or welfare of the consuming community is at  a  lower  level  than possible under  the  given production  conditions. Thus, monopoly has caused misallocation of resources.