A Level Economics AQA Practice Exam

What causes deadweight loss in a monopoly?

1. Efficiencies in production

2. Charging a price above marginal cost

3. Market entry of new competitors

4. A reduction in market demand

The correct answer is: Charging a price above marginal cost

Deadweight loss in a monopoly is primarily caused by the practice of charging a price above marginal cost. In a competitive market, firms typically set their prices equal to marginal cost, which maximizes consumer and producer surplus and leads to an efficient allocation of resources. However, a monopolist has the market power to set prices higher than marginal cost. When a monopoly charges a higher price, it restricts the quantity of goods produced and sold compared to what would occur in a competitive market. This leads to a decrease in consumer surplus because some consumers who would have purchased the product at a lower price are now unable to do so. The monopolist captures a larger producer surplus but the overall economic welfare is reduced because of the lost potential trades that would have happened at the lower price. As a result of this pricing strategy, there are consumers who value the product more than the marginal cost of production, but are excluded because of the high price, creating a situation where resources are not allocated efficiently. This misallocation of resources due to price distortion is what leads to the deadweight loss in a monopoly market structure.