A monopsony is the opposite of a monopoly. It is characterized as follows:
- Only One buyer
- Many sellers
- Buyers determine the price by the level they demand
- Buyers face an upward sloping supply curve
- There is one market price
A monopsony is a market structure where there are only one buyer (for example, a government who purchases military equipment might be an example of a monopsony).
This market structure leads to inefficiencies because buyers will purchase less goods then would be sold in an equilibrium of a competitive market. In the monopsony equilibrium the buyers will have a higher willingness to pay then the market price. This may seem counter-intuitive as if they value a good more then the market price, you might think they would just purchase more goods until their willingness to pay was the same as the market price. However, the problem is that every additional unit they buy, they need to increase the price for all other units they have purchased.
The above diagram show how the monopsony market operates. The single buyer has a demand curve. They face a market supply curve. There is a new curve here that you probably haven't seen yet though, the "marginal expenditure curve".
The marginal expenditure curve is the additional amount a buyer must pay when they buy another unit. It is not simply just the price because if they wish to buy another unit, they must increase the price they are willing to pay to entice more firms to enter the market. This means that for all previous units they buy, they must also pay a higher price for all other units. Therefore, the marginal expenditure curve is higher than the supply curve.
Analogous to how monopolies maximize expected profit where marginal revenue = marginal cost, a monopsony maximizes consumer surplus by setting marginal expenditure = marginal benefits. The marginal benefits is just the demand curve. Marginal expenditure is how much extra you must pay for another unit of consumption. The reason this must be the case is set out as follows:
- If marginal expenditure < marginal benefits, the consumer can increase their consumer surplus by purchasing another good.
- If marginal expenditure > marginal benefits, the last good the consumer purchased decreased their consumer surplus, so they should consumer less.
Since marginal expenditure cannot be larger or smaller than marginal benefits, it must be the case that they are equal.
Now as we can see in this diagram, there is a area shaded green. This is the dead weight loss. Because there are units where the marginal benefits > marginal cost of production the market experiences dead weight loss.
The price also corresponds to the point on the supply curve not demand like in the monopoly. In this case, the buyer has market power so can force sellers to charge a price P. if they tried to charge a price higher, the buyer would just buy from a different seller.
Thus just how a monopoly can cause under production and a price too high, monopsonies can cause underproduction and the price to be too low.
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