Principles of Economics: Efficiency
Efficiency Loss (aka Welfare Loss or Deadweight Loss)
We measure the efficiency loss of an output Qo by the difference between Price and
Marginal Cost (Supply) between the output Qo and optimal output at P = MC. It is the
difference between Demand and Marginal Cost (Supply) between given output and optimal
output. We will see that this is equivalent to the net loss of consumers’ surplus and producers’
surplus at the output relative to optimal output.
Competition => Optimum Allocation (Allocation Efficiency, 0 Efficiency Loss)
Since firms and households are price-takers in a competitive market, competitive market
equilibrium implies that P = MC, which implies that competitive markets give the optimal
allocation of resources.
Monopolies create efficiency loss by reducing output below competitive output and
increasing price above competitive price. Governments cannot regulate monopolies through
taxation, though, since per unit taxes decrease monopoly output by shifting up Marginal Cost and
fixed taxes do not change monopoly output since marginal cost doesn’t change.
Governments attempt to eliminate the efficiency loss caused by a monopoly by requiring
that a ‘normal’ monopoly produce the output where Price equals Marginal Cost (P = MC) and
that a natural monopoly produce the output where Price equals Average Cost.
1. Marginal Cost Pricing
The principal concern of government regulation of monopoly is to eliminate efficiency loss
not to eliminate monopoly profits. Marginal Cost Pricing (P = MC) as the requirement that the
monopoly produce the output where Price equals Marginal Cost is therefore the preferred option
for government regulation. The upper diagram below shows the efficiency loss due to a normal
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