Allocative inefficiency due to unregulated monopoly is characterized by the condition:
A) P = MC.
B) P = MR.
C) P > MC.
D) P > AVC.
The correct answer and explanation is :
The correct answer is C) P > MC.
Explanation:
Allocative inefficiency occurs when the allocation of resources is not optimal, meaning that the resources could be used in a way that would increase total welfare (consumer plus producer surplus). A monopoly, unlike perfectly competitive firms, has market power, which means it can influence the price of its product instead of taking the price as given (as a competitive firm does).
Why is “P > MC” the condition of allocative inefficiency in a monopoly?
In a perfectly competitive market, the price (P) equals the marginal cost (MC), which is the condition for allocative efficiency. This is because, under perfect competition, firms produce where price equals marginal cost (P = MC), ensuring that the value consumers place on the last unit produced (reflected by the price) equals the cost of producing that unit.
However, in the case of a monopoly, the firm has the ability to set prices above marginal cost. This happens because the monopolist is the sole producer in the market, and it maximizes profit by producing a quantity of output where marginal revenue (MR) equals marginal cost (MC), but the price consumers are willing to pay (P) is higher than this marginal cost.
This situation creates allocative inefficiency because the monopolist produces less output than would be produced in a competitive market. The monopolist restricts output to raise prices, which means that some consumers who are willing to pay a price that exceeds the marginal cost do not receive the product. The result is a loss of total welfare, which is the essence of deadweight loss.
In simpler terms, when P > MC, the monopolist is charging a price higher than the cost of producing the last unit, meaning there are potential gains from trade that are not being realized. The monopolist is not producing enough to meet all the demand at the efficient price level, leading to the inefficiency in resource allocation.
Therefore, the condition of allocative inefficiency in a monopoly is P > MC, since the monopolist is setting a price above the marginal cost of production.