IGCSE Economics 0455 – Market Failure: Monopoly and Misallocation of Resources
The Allocation of Resources – Market Failure
Key Concepts
Efficient allocation occurs when resources are used to produce the combination of goods and services most desired by society.
Market failure happens when the free market does not achieve this efficient outcome.
One common source of market failure is a monopoly, where a single firm controls the supply of a product.
How a Monopoly Restricts Supply
A monopoly maximises profit by equating marginal revenue (MR) to marginal cost (MC). Because the monopolist faces a downward‑sloping demand curve, MR lies below the demand curve. This leads to a lower output level than would occur in a perfectly competitive market.
Mathematically, the profit‑maximising condition is:
\$\text{MR}= \text{MC}\$
Since the demand curve is also the average revenue (AR) curve, the price charged by the monopoly is read from the demand curve at the profit‑maximising quantity:
\$P = D(Q_{\text{M}})\$
Implications of Restricted Supply
Higher Prices – With fewer units supplied, the price consumers must pay is above the competitive equilibrium price.
Deadweight Loss – The reduction in output creates a loss of total surplus (consumer + producer surplus) that is not transferred to any party.
Misallocation of Resources – Resources that could have been used to produce additional units are idle or diverted to less valued uses.
Reduced Consumer Welfare – Consumers either pay more for the same product or are forced to forgo the product altogether.
Comparison: Competitive Market vs Monopoly
Aspect
Perfect Competition
Monopoly
Number of firms
Many (price takers)
One (price maker)
Demand faced by firm
Perfectly elastic
Downward‑sloping
Profit‑maximising rule
MR = MC = P
MR = MC (P > MC)
Output level
QC (where P = MC)
QM (where MR = MC, QM < QC)
Price
P = MC
P > MC
Total surplus
Maximum (no deadweight loss)
Reduced (deadweight loss present)
Deadweight Loss Illustration
The area of deadweight loss (DWL) can be expressed as the triangle between the demand curve, the marginal cost curve, and the monopoly quantity.
Suggested diagram: Demand curve (D), marginal cost curve (MC), marginal revenue curve (MR). Show competitive equilibrium (EC) where D intersects MC, and monopoly equilibrium (EM) where MR intersects MC. Shade the deadweight loss triangle.
Why Misallocation Matters for Policy
Governments may intervene to correct the inefficiency (e.g., price regulation, breaking up monopolies, or encouraging competition).
Understanding the welfare loss helps justify public policies aimed at improving resource allocation.
In the IGCSE exam, students should be able to explain how restricted supply under a monopoly leads to higher prices and deadweight loss, and evaluate possible government responses.
Key Take‑aways
A monopoly restricts output to raise price above marginal cost.
This creates a deadweight loss, indicating a misallocation of resources.
Higher prices reduce consumer surplus, while the monopolist captures part of the surplus as profit.
Policy measures aim to move the market closer to the competitive outcome, thereby improving overall welfare.