(a) Explain how welfare loss may result from monopoly power.
– Explain characteristics of monopoly (single seller, price setter, unique product, BTE are high)
– Explain that welfare loss arises because the firms fail to allocate resources efficiently (they are not allocating at the optimal output which maximizes producer/consumer welfare) & are productive inefficient
– Explain how welfare is maximized (welfare is maximized at socially optimal output at Q where DD=SS, or AR=MC). this is where the allocation is said to be pareto optimal- where nobody can be made better off without anyone made worse off
*this is the diagram that shows welfare being maximized, it is not required and purely for your understanding of welfare being maximized or allocative efficiency achieved
– Because M is a price setter, it is able to determine its own price at MC=MR(which is the profit max level of output), assuming that maximize profits
– Therefore it earns more profit by producing less than the socially optimal output at Q1, it restricts output so that it can charge a higher price to max profit
– Also, the firm is productive inefficient because it fails to produce at the min AC; ie it is not maximizing the use of resources. It usually produces to the left of min AC, suggesting inability to maximize capacity
– Hence, there is under-allocation in this market, resulting in a loss of welfare represented by the red triangle (DWL)
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