Explain how monopoly causes an inefficient allocation of resources when the competitive firm does not, even when both seek to maximize profits

Question

What will be an ideal response?

Answer 1

Both monopolies and competitive firms will maximize profits where marginal revenue equals marginal cost. The difference is that in a competitive environment, marginal revenue is the same as the price. Therefore, price is equal to marginal cost and in the long run this will be at the minimum average cost level. This means that there are no economic profits, and there is vocative efficiency because consumers are paying a price equal to the marginal cost of the last product produced. Also, productive efficiency exists because P = minimum ATC.
However, the monopoly finds its marginal revenue is below the price it can obtain at each output level. This occurs because the monopolist faces a down sloping market demand curve, and to sell larger output, it must lower the price. Since the price is lowered on all units of output, the gain in total revenue is less than the price for each additional unit produced. That is, the marginal revenue is below the price. When a monopoly finds the output level where marginal revenue equals marginal cost, it then finds that it can sell that level of output at a price that exceeds the marginal revenue. Therefore, the consumer is paying a price that exceeds the marginal cost of production. This means locative efficiency is not achieved. If the price were allowed to fall to the marginal cost, the consumer would purchase a greater quantity at a lower price. Therefore, the monopoly situation is not efficient from the economic point of view. Specifically, there is an under allocation of resources (P > MC). Also, production does not occur at minimum average total cost so productive efficiency is not realized. There is also the possibility that a lack of competitive pressure will cause the monopolist to be less efficient in its production methods (x-inefficiency), so monopoly may not be as efficient in the production sense as is the competitive firm.