Answer to Question #208435 in Microeconomics for Kyle

Question

Consider a monopolized industry. Is the deadweight loss from this industry greater if (1) the government sets price equal to average total cost or (2) the government sets price equal to marginal cost? Why? Use examples of monopoly form your own country to answer this question.

Answer 1

Solution:

In a monopolized industry, the deadweight loss will be greater when the government sets prices equal to the total average cost.

This is because a monopoly normally maximizes its profits at the point where MR = MC and the price is set at the point where the line intersects the demand curve. A monopoly will always produce a lower output and charge a higher price which creates a deadweight loss to society.

When the government sets price equal to the marginal cost, the economy will reach an efficient outcome hence less or deadweight loss will be encountered.

On the other hand, when the government sets a price equal to the total average cost, then the deadweight loss will be greater. This is because this is the lowest point a monopoly can charge prices to cover its costs and it is lower than the marginal cost. At this point, a monopoly will produce less output at the given price creating a greater deadweight loss.