Question

Unlike perfect competition, a monopoly produces welfare loss. Briefly explain where it stems from (i.e., who loses welfare) by drawing a graph including both perfect competition and monopoly.

Answer 1

Under a perfect competition, price is determined by forces of demand and supply, whereas under a monopoly, the monopolist sets the price in order to maximize his profits. This results in a loss of welfare in the economy, also called the "deadweight loss".

The following image demonstrates the process of price determination under perfect competition:

The price is determined by the intersection of the demand and supply curves.

The following image demonstrates the process of price determination under a monopoly:

The deadweight loss comprises of loss of producer surplus and loss of consumer surplus. Unlike perfect competition, a monopolist sets its price when its marginal revenue is equal to the demand. Under a monopoly, the price is higher than perfect competition and equilibrium quantity is lower than perfect competition.