Question

2. Consider a firm with a patent on a good, so that it has a monopoly (without perfect price discrimination). Show that, if the firm chooses to produce, it would be more socially efficient for the firm to produce more than it will choose to produce in equilibrium. This suggests that a (sufficiently small) production subsidy could increase efficiency by encouraging more production for firms that decide to invent a (patentable) product. Can you think of another reason why a production subsidy could increase efficiency?

Answer 1

First, Monopoly firm tends to produce where MR = MC. Such condition of profit maximization does not satisfy the condition of socially optimal output. Socially optimal output is achieved where price (P) is equal to the MC (Marginal cost) of production. Hence, firm needs to raise its production level in order to satisfy condition of socially optimal level of output.

Production subsidy can increase efficiency where positive externalities exist. Production must be increased if positive externalities are there.