Monopoly and allocative efficiency
The efficiency definition, unchanged from AS91399
- Allocative efficiency occurs when the sum of consumer surplus and producer surplus is maximised.
- Equivalently, it occurs where D = S — where the value of the last unit to a consumer equals the cost of producing it.
- Deadweight loss indicates a market is allocatively inefficient.
Why a monopoly is allocatively inefficient
The argument is three lines and you must be able to give all three.
- At the profit maximising output, MR = MC.
- The price is read off AR, and AR lies above MR. Therefore P > MC.
- Since the demand curve is AR and the marginal cost curve is the supply relationship, P > MC means the market is not at D = S. Units that consumers value at more than they cost to make are not produced.
- The result is a deadweight loss triangle, and by the standard's own definition that means the market is allocatively inefficient.
Locating the deadweight loss
- The monopoly's output is Qe, where MR = MC.
- The allocatively efficient output is where AR (= D) crosses MC, which is further to the right. Call it Q_eff.
- The deadweight loss is the triangle bounded by:
- AR above,
- MC below,
- between Qe and Q_eff.
- Shade it and label it DWL.
Restricted output and a higher price
- Compare the monopoly against what a competitive industry with the same costs would do:
| Competitive outcome | Monopoly outcome | |
|---|---|---|
| Output | Q_eff, where D = MC | Qe, smaller |
| Price | Where D meets MC | Higher, read up to AR |
| Efficiency | P = MC, efficient | P > MC, inefficient |
| Deadweight loss | None | Triangle between Qe and Q_eff |
- The monopoly therefore restricts output and raises price relative to the efficient outcome, and the gap is exactly the deadweight loss.
What a monopoly is NOT criticised for
Be precise. Several things students say are not the efficiency argument:
-
Not "monopolies charge high prices". Any firm charges what maximises profit; the issue is that the profit-maximising price is above marginal cost.
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Not "monopolies make too much profit". Supernormal profit is a transfer from consumers to the firm, not a deadweight loss. It is a distribution point, not an efficiency point.
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Not "monopolies are inefficient at producing". That would be productive inefficiency, which is a different concept from the allocative efficiency this standard defines.
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The efficiency argument is only about the output being below the point where D = S, leaving a deadweight loss.
Worked ExampleExplaining why a monopoly is not allocatively efficient
An illustrative monopoly produces at its profit maximising output where:
- Marginal revenue = $30
- Marginal cost = $30
- The price read up to the AR curve = $70
At the output where AR crosses MC, price and marginal cost would both be $45.
Explain, referring to the model, whether the monopoly is allocatively efficient.
Step 1 — State the efficiency condition
A market is allocatively efficient when the sum of consumer surplus and producer surplus is maximised, which occurs where D = S — that is, where the value of the last unit to a consumer equals the marginal cost of producing it, so P = MC.
Step 2 — Find the monopoly's position
The monopoly profit maximises where MR = MC, which here is at 30. That fixes its output at Qe.
The price is read up from Qe to the AR curve, giving Pe = $70.
Step 3 — Compare P with MC
Pe = $70 and MC = $30.
P > MC, by $40 on the last unit produced.
Step 4 — Say what that means
The last unit the monopoly produces is worth $70 to the consumer who buys it, but it costs only $30 to make. The gap of $40 means there are further units which consumers would value at more than they cost to produce — anywhere up to the output where AR meets MC at $45.
Those units would each create surplus. The monopoly chooses not to produce them, because producing them would require lowering the price on every unit, which would reduce its profit.
Step 5 — Identify the deadweight loss
The monopoly produces Qe, where MR = MC.
The allocatively efficient output is Q_eff, where AR (= D) crosses MC — at a price and marginal cost of $45. Q_eff is to the right of Qe.
Between Qe and Q_eff, the AR curve lies above the MC curve, so every unit in that range is worth more than it costs. None of them is produced.
The deadweight loss is the triangle bounded by AR above, MC below, between Qe and Q_eff.
Step 6 — State the verdict
The monopoly produces where MR = MC, not where D = S. Because P > MC and a deadweight loss exists, the sum of consumer and producer surplus is not maximised.
The monopoly is therefore allocatively inefficient.
Step 7 — What is not part of this argument
The monopoly's supernormal profit is a transfer from consumers to the firm. It is not part of the deadweight loss, and it is not the reason the market is inefficient. The inefficiency is the restricted output alone.