Implications of misallocation of resources in relation to restricted supply causing higher prices under a monopoly

1 The Basic Economic Problem & Factors of Production

1.1 Scarcity and the basic economic problem

• Scarcity: Unlimited human wants but limited resources.
• Because of scarcity societies must answer three fundamental questions:

  1. What goods and services should be produced?
  2. How should they be produced?
  3. For whom should they be produced?

1.2 Factors of production and their rewards

1.3 Production Possibility Curve (PPC)

• Shows the maximum combinations of two goods that an economy can produce with existing resources and technology.
• Key points:

  • On the curve: Efficient use of resources.
  • Inside the curve: Inefficient – some resources are idle or mis‑used.
  • Outside the curve: Unattainable with current resources.

• Shift of the PPC outward = economic growth (more resources or better technology).

2 Demand, Supply and Price Determination

2.1 Demand

• Definition: The quantity of a good that consumers are willing and able to buy at each possible price, ceteris paribus.
• Law of demand: As price falls, quantity demanded rises (downward‑sloping demand curve).
• Determinants (shifters): Consumer income, tastes & preferences, price of related goods, expectations, number of buyers.
• Movement vs. shift:

  • Movement along the curve – caused by a change in the good’s own price.
  • Shift of the whole curve – caused by a change in any determinant other than price.

• Individual vs. market demand: Market demand = horizontal sum of all individual demand curves.

2.2 Supply

• Definition: The quantity of a good that producers are willing and able to sell at each possible price, ceteris paribus.
• Law of supply: As price rises, quantity supplied rises (upward‑sloping supply curve).
• Determinants (shifters): Input prices, technology, expectations, number of sellers, taxes/subsidies.
• Movement vs. shift:

  • Movement along the curve – caused by a change in the good’s own price.
  • Shift of the whole curve – caused by a change in any other determinant.

• Individual vs. market supply: Market supply = horizontal sum of all individual supply curves.

2.3 Market equilibrium

• Equilibrium occurs where Q_D = Q_S – the point where the demand and supply curves intersect.
• At this price:

  • There is no shortage (excess demand) or surplus (excess supply).
  • Consumer surplus = area above price and below demand curve.
  • Producer surplus = area below price and above supply curve.

• If the price is set above equilibrium → surplus → price tends to fall.
• If the price is set below equilibrium → shortage → price tends to rise.

2.4 Elasticity

Worked example (PED): If a 10 % fall in price leads to a 20 % rise in quantity demanded, PED = –20 % / 10 % = –2 (elastic).

3 Market Economic System & Market Failure

3.1 Market (price‑taking) economy

• Resources are allocated mainly by the forces of demand and supply; firms are price‑takers.

3.2 Market failure

A market fails when the equilibrium does not maximise total (consumer + producer) surplus. The resulting misallocation of resources means that some resources are either under‑used or used to produce goods that society values less than alternative uses.

3.3 Causes of market failure (syllabus list)

• Monopoly power – a single firm restricts output to raise price.
• Public goods – non‑rival and non‑excludable (e.g., street lighting); the market supplies too little.
• Externalities

  • Negative externality – a cost imposed on third parties (e.g., pollution).
  • Positive externality – a benefit enjoyed by third parties (e.g., vaccination).

• Merit and de‑merit goods

  • Merit good – socially desirable but under‑consumed (e.g., education).
  • De‑merit good – socially undesirable but over‑consumed (e.g., cigarettes).

3.4 Monopoly as a source of market failure

How a monopoly restricts supply

• The monopolist chooses output where marginal revenue (MR) = marginal cost (MC).
• Because the firm faces a downward‑sloping demand curve, each extra unit sold forces the price of *all* units to fall; therefore MR lies below the demand (average revenue) curve.
• At the profit‑maximising quantity Q_M, the price is read from the demand curve:

  \$P{\text{M}} = D(Q{\text{M}})\$

• Since MR = MC and MR < D, the monopoly price is above marginal cost:

  \$P_{\text{M}} \; > \; MC\$

Diagram description (exam tip)

Draw the following on one graph:

• Downward‑sloping demand curve (D) = average revenue (AR).
• Marginal revenue curve (MR) lying below D.
• Upward‑sloping marginal cost curve (MC).
• Competitive equilibrium (E_C) where D meets MC – here P = MC.
• Monopoly equilibrium (E_M) where MR meets MC – read Q_M on the horizontal axis and P_M on D.
• Shade the triangle between D, MC and the vertical line at Q_M – this is the dead‑weight loss (DWL).

Key formulae

Dead‑weight loss (DWL) created by the monopoly:

\$\text{DWL}= \frac{1}{2}\,(P{\text{M}}-MC)\,(Q{\text{C}}-Q_{\text{M}})\$

where Q_C is the competitive output (where P = MC).

Consequences of restricted supply under monopoly

1. Higher price – consumers pay P_M, which is above the competitive price (P = MC).
2. Dead‑weight loss – loss of total surplus shown by the shaded triangle; it represents a misallocation of resources.
3. Misallocation of resources – resources that could have produced additional units are idle or used for less‑valued activities.
4. Reduced consumer welfare – consumer surplus falls; part of the lost surplus becomes monopoly profit, the rest is DWL.

3.5 Perfect competition vs. monopoly (summary table)

4 Mixed Economic System & Government Intervention

4.1 Definition of a mixed economy

A mixed economic system combines private enterprise with government involvement. The state intervenes where the market fails, aiming to improve efficiency, equity and social welfare.

4.2 Why governments intervene (link to market failure)

• To correct inefficiencies caused by monopoly power, public‑good under‑provision, externalities, and merit/de‑merit goods.
• To redistribute income and protect consumers from excessively high prices.

4.3 Government tools to correct market failure (monopoly focus)

4.4 Evaluation of interventions for monopoly

• Price regulation

  • Pros: Reduces price, increases output, improves consumer welfare.
  • Cons: If the ceiling is set too low the firm may incur losses, cut quality, or exit the market.

• Breaking up the monopoly

  • Pros: Introduces competition, pushes price toward MC, eliminates DWL.
  • Cons: Can be costly, may duplicate infrastructure, and transition can be disruptive.

• Nationalisation

  • Pros: Government can set price = MC, removing DWL and ensuring universal access.
  • Cons: Risk of bureaucratic inefficiency, weaker profit motive, possible under‑investment.

• Subsidies

  • Pros: Encourage higher output of merit goods, lower price for consumers.
  • Cons: Require taxpayer funding, may be mis‑directed if not well‑targeted, can create fiscal burden.

4.5 Key take‑aways (exam checklist)

• Market failure = inefficient allocation of resources; monopoly is a classic cause.
• Monopoly restricts output (MR = MC) and charges a price above marginal cost, creating a dead‑weight loss.
• Higher price and reduced output mean a misallocation of resources and lower consumer welfare.
• In a mixed economy the government can intervene with:

  • Price controls, taxes, subsidies, regulation, nationalisation, privatisation, direct provision, quotas.

• When answering IGCSE questions, students should be able to:

  1. Define market failure and list its main causes.
  2. Explain how a monopoly restricts supply, show the MR = MC rule, and calculate/describe dead‑weight loss.
  3. Discuss welfare consequences (higher price, loss of CS, DWL).
  4. Evaluate at least two government interventions, weighing benefits against drawbacks.