Economics
Monopoly Pricing and Deadweight Loss
Quick fact
A monopolist's profit-maximizing price is always above marginal cost, but it is not the maximum price consumers would pay; it's the price that balances losing customers with earning more per sale.
Why this is interesting
You might think a monopoly charges the highest possible price—but that's not true. The actual price is lower than that, yet it still leaves society worse off. Why?
Read the full explanation
Understanding Monopoly Pricing and Deadweight Loss
Imagine the only bakery in town sells bread. It can choose any price. At a very high price, few people buy; at a low price, many buy, but profit per loaf is small. The baker wants to find the sweet spot that maximizes total profit. To do this, the baker compares: if I lower the price a little, I attract a few more customers, but I also earn less on the bread I sell to everyone. The baker keeps lowering the price only as long as the extra revenue from new customers outweighs the loss on existing ones. The profit-maximizing price is where that trade-off balances—where marginal revenue equals marginal cost. But notice: at that price, there are still people who value bread more than it costs to make it, but who won't buy because the price is too high. These are the lost trades.
A deeper explanation
The key is that a monopolist faces a downward-sloping demand curve. Unlike a perfectly competitive firm, which takes the market price as given, the monopolist's price affects quantity demanded. When the monopolist sells one more unit, it must lower the price on all units sold, so the marginal revenue from an extra unit is less than its price. Profit maximization occurs where marginal revenue equals marginal cost. Because marginal revenue is below demand, the price that clears the market is above marginal cost. This creates a deadweight loss: the surplus that would have been generated by trades between marginal cost and the demand curve—trades that consumers value more than they cost to produce—is simply not realized. These potential trades would have increased both consumer surplus and producer surplus, but the monopolist forgoes them to support a higher price on its existing output. Deadweight loss is the triangle of lost total surplus. This inefficiency is the economic justification for antitrust laws and regulation.