Question

PART C features an essay-type question with three subparts and requires to provide a full analysis of the social cost of the output decision of a profit maximizing monopoly firm, assuming that the firm is the only producer in a market.

Thoroughly discuss:

1. The concept of social cost in terms of the output decision of the monopoly firm;

Answer 1

A monopoly has market power and operates in order to maximize his profit. He produces at a level where MR=MC and P>MC. However if we recall the case of perfect competition, output is produced at the point where P=MR=MC. Basically monopolists have a seperate AR and MR curve. Hence monopoly earns super normal profits. However to do so there is a social cost in terms of efficiency loss due to inefficient allocation of resources and the excess capacity that is present with the monopoly firm.

Consider the diagram in the image. The diagram shows the difference in total surplus for PC firms and Monopoly firm. When firms operate under PC, they produce at Ep equilibrium point where P=MC, price is Pp and quantity produced is qp. The consumer surplus is given by the area DPpEp and producer surplus is the area PpEpT. On the contrary when monopoly firms fix price and quantity at their profit maximization level, they produce at Em equilibrium where price is Pm and quantity is qm. The consumer surplus is less now, equal to the area DPmEm while producer surplus is equal to PmEmET area. Notice that in monopoly the area EmEEp did not incurr to anybody and this is the area lost due to the market being a monopoly. Hence this area is the deadweight loss of the society meaning that due to higher monopoly prices and the lower quantity they produce in contrast to PC, eliminates some on the transactions that previously occured in a PC market structure. The area of dead weight loss is the efficieny loss and is the social cost of monopoly.