IBonomicsMonopoly – Abnormal Profit and Welfare LossHL
MicroeconomicsA diagram illustrating a monopolist earning abnormal profit. The firm restricts output to Qm where MC = MR and sets price Pm, resulting in welfare loss and consumer surplus loss compared to a perfectly competitive outcome.
Curves and elements
- ar
- AR = D: The average revenue or demand curve, downward sloping due to price-setting power.
- mr
- MR: Marginal Revenue, lies below AR for monopolies.
- mc
- MC: Marginal Cost, intersects MR at the profit-maximizing quantity Qm.
- atc
- ATC: Average Total Cost, used to calculate the firm's level of profit.
- q
- Qm: The monopolist's profit-maximizing quantity where MC = MR.
- p
- Pm: The price charged by the monopolist at Qm, found on the AR curve.
- pc
- Pc: The allocatively efficient price that would exist in a perfectly competitive market, where MC intersects the AR (demand) curve.
Key explanations
- 1
A monopolist maximizes profit where marginal cost (MC) equals marginal revenue (MR), producing quantity Qm.
- 2
The price Pm is set by extending a vertical line from Qm up to the demand curve (AR = D).
- 3
Since Pm is greater than average total cost (ATC) at Qm, the firm earns abnormal profit (shown in pink).
- 4
The price Pc represents the price that would exist under perfect competition, where MC = AR. This is the allocatively efficient point.
- 5
The shaded welfare loss triangle represents the loss of societal welfare due to the monopolist underproducing relative to the socially optimal quantity.
- 6
Monopolies lead to market failure because they do not produce at the socially efficient output (MC ≠ AR).
Example exam question
Using a diagram, explain how a monopoly earns abnormal profit and why this results in welfare loss.
Show example answer
A monopoly maximizes profit where MR = MC, which determines the quantity Qm. The price is set at Pm on the demand curve. Since Pm > ATC at Qm, the firm earns abnormal profit. However, this output is less than the allocatively efficient quantity where MC = AR (Pc), creating a welfare loss. This deadweight loss indicates reduced overall societal welfare due to underproduction.
