However, profit maximizing has little do with individual consumer responsiveness, but the overall market. As we know profit is maximized where the Marginal Cost incremental cost is equal to the Marginal Revenue incremental revenue , which is at a positive intersect on the elastic region of the demand curve, which achieves a higher price than on the inelastic region, with less output less production costs , resulting in a greater profit for the monopolist.
In terms of revenue, the monopoly will also always operate where the Marginal Revenue MR curve is positive to ensure an optimal total revenue.
The region in which the MR curve is positive is always demand elastic. Note: during a session a monopoly graph would be shown with points,curves and regions on display. For example, a pizza restaurant can easily double production from one pizza per hour to two without hiring additional employees or buying more sophisticated equipment.
When production reaches 50 pizzas per hour, however, it may be difficult to grow without investing a lot of money in more skilled employees or more high-tech ovens. This trend is reflected in the upward-sloping portion of the marginal cost curve. The marginal revenue curve for monopolies, however, is quite different than the marginal revenue curve for competitive firms.
Monopolies have much more power than firms normally would in competitive markets, but they still face limits determined by demand for a product. Higher prices except under the most extreme conditions mean lower sales. Therefore, monopolies must make a decision about where to set their price and the quantity of their supply to maximize profits. They can either choose their price, or they can choose the quantity that they will produce and allow market demand to set the price.
Since costs are a function of quantity, the formula for profit maximization is written in terms of quantity rather than in price. In this formula, p q is the price level at quantity q. The cost to the firm at quantity q is equal to c q. Since revenue is represented by pq and cost is c, profit is the difference between these two numbers.
As a result, the first-order condition for maximizing profits at quantity q is represented by:. Monopolies will produce at quantity q where marginal revenue equals marginal cost. Then they will charge the maximum price p q that market demand will respond to at that quantity. Consider the example of a monopoly firm that can produce widgets at a cost given by the following function:.
The price of widgets is determined by demand:. How can we maximize this function? In this case:. Consider the diagram illustrating monopoly competition.
The key points of this diagram are fivefold. We see that the monopoly restricts output and charges a higher price than would prevail under competition. Monopoly Diagram : This graph illustrates the price and quantity of the market equilibrium under a monopoly. To maximize output, monopolies produce the quantity at which marginal supply is equal to marginal cost.
A pure monopoly has the same economic goal of perfectly competitive companies — to maximize profit. If we assume increasing marginal costs and exogenous input prices, the optimal decision for all firms is to equate the marginal cost and marginal revenue of production. Nonetheless, a pure monopoly can — unlike a firm in a competitive market — alter the market price for its own convenience: a decrease of production results in a higher price. Like non-monopolies, monopolists will produce the at the quantity such that marginal revenue MR equals marginal cost MC.
However, monopolists have the ability to change the market price based on the amount they produce since they are the only source of products in the market. When a monopolist produces the quantity determined by the intersection of MR and MC, it can charge the price determined by the market demand curve at the quantity.
Therefore, monopolists produce less but charge more than a firm in a competitive market. Monopoly Production : Monopolies produce at the point where marginal revenue equals marginal costs, but charge the price expressed on the market demand curve for that quantity of production.
Monopolies, unlike perfectly competitive firms, are able to influence the price of a good and are able to make a positive economic profit. An important consequence is worth noticing: typically a monopoly selects a higher price and lesser quantity of output than a price-taking company; again, less is available at a higher price.
This says that when the price is one, the market will demand 28 widgets; when the price is two, the market will demand 26 widgets; and so on. We know that all firms maximize profit by setting marginal costs equal to marginal revenue. Finding this point requires taking the derivative of total revenue and total cost in terms of quantity and setting the two derivatives equal to each other. The market for a good is depicted on the left hand side of Figure 2.
The market price is found at the market equilibrium left panel , where market demand equals market supply. For the individual competitive firm, price is fixed and given at the market level right panel. Therefore, the demand curve facing the competitive firm is perfectly horizontal elastic , as shown in Figure 3.
The price is fixed and given, no matter what quantity the firm sells. When substituted into Equation 3. If a competitive firm increases price, it loses all customers: they have perfect substitutes available from numerous other firms. Monopoly power, also called market power, is the ability to set price.
Firms with market power face a downward sloping demand curve. When this is substituted into Equation 3. The markup the level of price above marginal cost for this firm is two times the cost of production.
The size of the optimal, profit-maximizing markup is dictated by the elasticity of demand. Firms with responsive consumers, or elastic demands, will not want to charge a large markup. Firms with inelastic demands are able to charge a higher markup, as their consumers are less responsive to price changes. In the next section, we will discuss several important features of a monopolist, including the absence of a supply curve, the effect of a tax on monopoly price, and a multiplant monopolist.
There is no supply curve for a monopolist. This differs from a competitive industry, where there is a one-to-one correspondence between price P and quantity supplied Q s. For a monopoly, the price depends on the shape of the demand curve, as shown in Figure 3. A supply curve, then, requires a single price P for each quantity Q.
This graph shows that there is more than one price associated with each quantity. Since there is more than one price associated with a single quantity Q 0 , there is no one-to-one correspondence between price and quantity supplied, and no supply curve for a monopolist. In a competitive industry, a tax results in an increase in price that is based on the incidence of the tax.
The price increase is a fraction of the tax, less than the tax amount. The tax incidence depends on the magnitude of the elasticities of supply and demand. In a monopoly, it is possible that the price increase from a tax is greater than the tax itself, as shown in Figure 3. This is an interesting and nonintuitive result! In this case, consumers of the monopoly good are paying more than percent of the tax rate.
This is because of the shape of the demand curve: it is profitable for the monopoly to reduce quantity produced to increase the price. Suppose that a monopoly has two or more plants factories. How does the monopolist determine how much output should be produced at each plant? Profit-maximization suggests two guidelines for the multiplant monopolist. Suppose that the monopolist operates n plants.
A mathematical model of a multiplant monopolist demonstrates profit-maximization. The result is interesting and important, as it shows that multiplant firms will not always close older, less efficient plants. This is true even if the older plants have higher production costs than newer, more efficient plants.
Suppose that a monopolist has two plants, and total output Q T is the sum of output produced in plant 1 Q 1 and plant 2 Q 2. The profit-maximizing model for the two-plant monopolist yields the solution. The costs of producing output in each plant differ. The multiplant monopolist solution is shown in Figure 3.
The marginal cost curve for plant 1 is higher than the marginal cost curve for plant 2, reflecting the older, less efficient plant.
Rather than shutting the less efficient plant down, the monopolist should produce some output in each plant, and set the MC of each plant equal to MR, as shown in the graph. The outcome of the multiplant monopolist yields useful conclusions for any firm: continue using any input, plant, or resource until marginal costs equal marginal revenues.
Less efficient resources can be usefully employed, even if more efficient resources are available. The next section will explore the determinants and measurement of monopoly power, also called market power.
In this section, the determinants and measurement of monopoly power are examined. Economists use the Lerner Index to measure monopoly power, also called market power. The index is the percent markup of price over marginal cost.
A monopolist will have a Lerner Index greater than zero, and the index will be determined by the amount of market power that the firm has. A larger Lerner Index indicates more market power. In Section 3. Substitution of this pricing rule into the definition of the Lerner Index provides the relationship between the percent markup and the price elasticity of demand.
An example of a Lerner Index might be Big Macs. There are substitutes available for Big Macs, so if the price increases, consumers can buy a competing brand such as Whoppers. In the case of a good with close substitutes, the price elasticity of demand is larger more elastic , causing the percent markup to be smaller: the Lerner Index is relatively small. A monopoly is defined as a single seller in an industry with no close substitutes.
Therefore, a monopoly that produces a good with no close substitutes would have a higher Lerner Index. A second pricing rule can be derived from equation 3. This is a useful equation, as it relates price to marginal cost. The price is two times the production costs in this case.
To summarize:. A monopoly example is useful to review monopoly and the Lerner Index. Profit-maximization yields the optimal monopoly price and quantity.
To calculate the value of the Lerner Index, price and marginal cost are needed equation 3. This is the first derivative of the inverse demand function. The same result was achieved using both methods, so the Lerner Index for this monopoly is equal to 0. The competitive price and quantity are P c and Q c. The welfare analysis of a monopoly relative to competition is straightforward. Consumers are losers, and the benefits of monopoly depend on the magnitudes of areas A and C.
Since a monopolist faces an inelastic supply curve no close substitutes , area A is likely to be larger than area C, making the net benefits of monopoly positive. The monopoly example from the previous section 3.
The competitive solution is found where the demand curve intersects the marginal cost curve. The welfare analysis of monopoly has been used by the government to justify breaking up monopolies into smaller, competing firms.
In food and agriculture, many individuals and groups are opposed to large agribusiness firms. One concern is that these large firms have monopoly power, which results in a transfer of welfare from consumers to producers, and deadweight loss to society. It will be shown below that outlawing or banning monopolies would have both benefits and costs. There is some economic justification for the existence of large firms due to economies of scale and natural monopoly, as will be explored below.
Next, the sources of monopoly power will be listed and explained. The price elasticity of demand depends on how large the firm is relative to the market. However, if all firms in the market increase the price of the good, consumers have no close substitutes, so must pay the higher price Figure 3. The second determinant of market power is the number of firms in an industry.
This is related to Figure 3. If a firm is the only seller in an industry, then the firm is the same as the market, and the price elasticity of demand is the same for both the firm and the market. The more firms there are in a market, the more substitutes a consumer has available, making the price elasticity of demand more elastic as the number of firms increases.
To summarize, the more firms there are in an industry, the less market power the firm has.
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