Question

Explain why market power reduces social welfare and identify two types of government policies aimed at reducing deadweight loss.

Short answer

Market power reduces social welfare by producing comparatively less output than the efficient output level.

Price regulation and anti-thrust polices are government policies that aim at reducing deadweight loss.

Step-by-step solution

Market power reduces social welfare.

Market power increases the price to a level greater than the marginal cost borne by the monopolist. Thus, increasing the cost the society has to bear for gaining one unit of output decreases welfare.

As shown in the diagram above, the monopoly will charge a higher price than equilibrium, denoted as PM. Thus, the consumer surplus decreased from AP1E at normal equilibrium to APMB at monopolist price, thus decreasing social welfare.

Government Policies

1. Price regulation:

The government allows the firm to be a monopoly but controls its price to decrease the deadweight loss. If the government sets a price at $80, it will increase the consumer surplus from the initial monopoly level.

Hence, from the diagram above, one can understand that the consumer surplus has increased to PRAE, and the deadweight loss is no longer present. Thus, in turn, increasing social welfare.

ii . Anti-trust policies

In this case, these policies were created by the government to ban the managers of the firms from engaging in activities that lead to collusive or monopoly practices. Thus, this incident eliminates the deadweight loss.