Welfare Aspects of Monopoly

Under perfect competition, the perfectly competitive equilibrium is efficient in resource allocation because it maximizes the sum of producer surplus and consumer surplus. But the situation is entirely different under a monopoly which maximizes its profit by producing an output where the price is more than the marginal cost. This results in higher prices and lower quantities and makes the firm better off and consumers worse off.

Monopoly is often criticized because it results in economic inefficiency in resource allocation. Economic efficiency is achieved when resources are allocated among the production of goods such that it maximizes social welfare.

Under a monopoly, resources are misallocated and resulting in a loss of social welfare. When a product is sold under conditions of monopoly, the price that consumers are paying is more than the marginal cost. Due to this higher price, the monopolist gains at the expense of consumers.

Dead weight-loss of Monopoly Equilibrium

This is shown in Fig 1. The perfectly competitive equilibrium would occur at point Ec where the price is equal to the marginal cost. The perfectly competitive price is OPc, and the quantity is OQc.

At price OPc,

Consumer Surplus = Area 1 + Area 2+ Area 3

Producer Surplus= Area 4 + Area 5

The monopolist is in equilibrium at point Em where MR is equal to MC. The monopolist price is OPm, and the quantity is OQm. Now because of the monopoly, the price rises to OPm, and consumer surplus reduces in Areas 2 and area 3. Consumers are losing area 3 because the output is reduced to OQm from OQc. Consumers also lose area 2 because now the price has risen from Pc to Pm, and that area is now transferred to the monopolist.

Producer Surplus under competitive equilibrium is the sum of area 4 and area 5. Now because of the monopoly, the price has risen to OPm from OPc and the producer surplus reduced by area 5 because output has now been reduced from OQc to OQm. And monopolist gains area 2 from the consumers because of higher price. The loss to the producer is less than its gain. Thus area 3 and area 5 are loss to society.

Deadweight Loss from Monopoly Power

At perfect competitive price OPc,

Consumer Surplus=1+2+3

Producer Surplus=4+5

At Monopoly Price OPm,

Consumer loss=2+3

Producer Gain=2-5

The Dead Weight Loss to the Society= -5-3=-(5+3)

The deadweight loss from monopoly power is given by shaded areas, i.e. area 3 and area 5. The deadweight loss resulting from monopoly accounts for its Allocative inefficiency.

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