How Monopolies Make Production and Pricing Decisions
Now that we know how monopolies arise, we can consider how a monopoly firm decides how much of its product to make and what price to charge it at.
Monopoly vs. Competition
The key difference between a competitve firm and a monoply is the monopoly's ability to influence the price of its output.
Monopoly vs. Competition
When we analyse profit maximization by competitive firms, we draw the market price as a horizontal line. Because a competitive firm can sell as much or as little as it wants at this price, the competitive firm faces a horizontal demand curve. Because the competitive firm sells a product with many substitutes, the demand curve that any one firm faces is perfectly elastic. The monopolist’s demand curve slopes downwards. If the monopolist raises the price of its good, consumers buy less of it. If the monopolist reduces the quantity of output it sells, the price of its output increases. The market demand curve provides a constraint on a monopoly’s ability to profit from its market power. With competitive firms, we assume that the monopolist’s goal is to maximize profit. Because the firm’s profit is total revenue minus total costs, our next task in explaining monopoly behaviour is to examine a monopolist’s revenue.
A competitive firm is small relative to to the market in which it operates and takes the price of its output as given by market conditions. By contrast, because a monopoly is the sole producer in its market, it can alter the price of its good by adjusting the quantity it supplies to the market. One way to view this difference between a competitve firm and a monopoly is to consider the demand curve that each firm faces.
A Monopoly's Revenue
A Monopoly's Revenue
The first two columns show the monopolist’s demand schedule. If you graphed these two columns of numbers, you would get a typical downwards sloping demand curve. The third column of the table presents the monopolist’s total revenue. It equals the quantity sold (from the first column) times the price (from the second column).
The fourth column computes the firm’s average revenue, the amount of revenue the firm receives per unit sold. Compute average revenue by taking the number for total revenue in the third column and dividing it by the quantity of output in the first column. Average revenue always equals the price of the good. The last column of Table 14.1 computes the firm’s marginal revenue, the amount of revenue that the firm receives for each additional unit of output.
The fourth column computes the firm’s average revenue, the amount of revenue the firm receives per unit sold. We compute average revenue by taking the number for total revenue in the third column and dividing it by the quantity of output in the first column. Average revenue always equals the price of the good. The last column of Table 14.1 computes the firm’s marginal revenue, the amount of revenue that the firm receives for each additional unit of output.
Table 14.1 shows a result that is important for understanding monopoly behaviour: a monopolist’s marginal revenue is always less than the price of its good. (Mankiw & Taylor, 2014, p.296)
Marginal revenue for monopolies is very different from marginal revenue for competitive firms. When a monopoly increases the amount it sells, it has two effects on total revenue (P × Q):
• The output effect. More output is sold, so Q is higher, which tends to increase total revenue.
• The price effect. The price falls, so P is lower, which tends to decrease total revenue.
Because a competitive firm can sell all it wants at the market price, there is no price effect. When it increases production by 1 unit, it receives the market price for that unit, and it does not receive any less for the units it was already selling.
Profit Maximization
The key difference between a competitve firm and a monoply is the monopoly's ability to influence the price of its output.
Profit Maximization
Figure 14.4 graphs the demand curve, the marginal revenue curve and the cost curves for a monopoly firm.
Suppose that the firm is producing at a low level of output, such as Q1. In this case, marginal cost is less than marginal revenue. If the firm increased production by 1 unit, the additional revenue would exceed the additional costs, and profit would rise. When marginal cost is less than marginal revenue, the firm can increase profit by producing more units.
A similar argument applies at high levels of output, such as Q2. In this case, marginal cost is greater than marginal revenue. If the firm reduced production by 1 unit, the costs saved would exceed the revenue lost. If marginal cost is greater than marginal revenue, the firm can raise profit by reducing production.
In the end, the firm adjusts its level of production until the quantity reaches QMAX, at which marginal revenue equals marginal cost. The monopolist’s profit-maximizing quantity of output is determined by the intersection of the marginal revenue curve and the marginal cost curve, this inter- section occurs at point A.
Remember that competitive firms maximize profit at the quantity of output at which marginal rev- enue equals marginal cost. In following this rule for profit maximization, competitive firms and mono- polies are alike. But there is also an important difference between these types of firm: the marginal revenue of a competitive firm equals its price, whereas the marginal revenue of a monopoly is less than its price. That is:For a competitive firm: P = MR = MC For a monopoly firm: P > MR = MC
A Monopoly's Profit
How much profit does a monopoly make?
A Monopoly's Profit
To see the monopoly’s profit, recall that profit (π) equals total revenue (TR) minus total costs (TC): π = TR − TC We can rewrite this as: π = (TR/Q − TC/Q) × Q TR/Q is average revenue, which equals the price P and TC/Q is average total cost ATC. Therefore: π = (P − ATC) × Q This equation for profit (which is the same as the profit equation for competitive firms) allows us to meas- ure the monopolist’s profit in our graph. Consider the shaded box in Figure 14.5. The height of the box (the segment BC) is price minus average total cost, P − ATC , which is the profit on the typical unit sold. The width of the box (the segment DC) is the quantity sold QMAX. Therefore, the area of this box is the monopoly firm’s total profit.
How Monopolies make Production and Pricing Decisions
joanna.prusak
Created on December 1, 2020
Start designing with a free template
Discover more than 1500 professional designs like these:
View
Smart Presentation
View
Practical Presentation
View
Essential Presentation
View
Akihabara Presentation
View
Pastel Color Presentation
View
Terrazzo Presentation
View
Visual Presentation
Explore all templates
Transcript
How Monopolies Make Production and Pricing Decisions
Now that we know how monopolies arise, we can consider how a monopoly firm decides how much of its product to make and what price to charge it at.
Monopoly vs. Competition
The key difference between a competitve firm and a monoply is the monopoly's ability to influence the price of its output.
Monopoly vs. Competition
When we analyse profit maximization by competitive firms, we draw the market price as a horizontal line. Because a competitive firm can sell as much or as little as it wants at this price, the competitive firm faces a horizontal demand curve. Because the competitive firm sells a product with many substitutes, the demand curve that any one firm faces is perfectly elastic. The monopolist’s demand curve slopes downwards. If the monopolist raises the price of its good, consumers buy less of it. If the monopolist reduces the quantity of output it sells, the price of its output increases. The market demand curve provides a constraint on a monopoly’s ability to profit from its market power. With competitive firms, we assume that the monopolist’s goal is to maximize profit. Because the firm’s profit is total revenue minus total costs, our next task in explaining monopoly behaviour is to examine a monopolist’s revenue.
A competitive firm is small relative to to the market in which it operates and takes the price of its output as given by market conditions. By contrast, because a monopoly is the sole producer in its market, it can alter the price of its good by adjusting the quantity it supplies to the market. One way to view this difference between a competitve firm and a monopoly is to consider the demand curve that each firm faces.
A Monopoly's Revenue
A Monopoly's Revenue
The first two columns show the monopolist’s demand schedule. If you graphed these two columns of numbers, you would get a typical downwards sloping demand curve. The third column of the table presents the monopolist’s total revenue. It equals the quantity sold (from the first column) times the price (from the second column).
The fourth column computes the firm’s average revenue, the amount of revenue the firm receives per unit sold. Compute average revenue by taking the number for total revenue in the third column and dividing it by the quantity of output in the first column. Average revenue always equals the price of the good. The last column of Table 14.1 computes the firm’s marginal revenue, the amount of revenue that the firm receives for each additional unit of output. The fourth column computes the firm’s average revenue, the amount of revenue the firm receives per unit sold. We compute average revenue by taking the number for total revenue in the third column and dividing it by the quantity of output in the first column. Average revenue always equals the price of the good. The last column of Table 14.1 computes the firm’s marginal revenue, the amount of revenue that the firm receives for each additional unit of output.
Table 14.1 shows a result that is important for understanding monopoly behaviour: a monopolist’s marginal revenue is always less than the price of its good. (Mankiw & Taylor, 2014, p.296) Marginal revenue for monopolies is very different from marginal revenue for competitive firms. When a monopoly increases the amount it sells, it has two effects on total revenue (P × Q): • The output effect. More output is sold, so Q is higher, which tends to increase total revenue. • The price effect. The price falls, so P is lower, which tends to decrease total revenue. Because a competitive firm can sell all it wants at the market price, there is no price effect. When it increases production by 1 unit, it receives the market price for that unit, and it does not receive any less for the units it was already selling.
Profit Maximization
The key difference between a competitve firm and a monoply is the monopoly's ability to influence the price of its output.
Profit Maximization
Figure 14.4 graphs the demand curve, the marginal revenue curve and the cost curves for a monopoly firm. Suppose that the firm is producing at a low level of output, such as Q1. In this case, marginal cost is less than marginal revenue. If the firm increased production by 1 unit, the additional revenue would exceed the additional costs, and profit would rise. When marginal cost is less than marginal revenue, the firm can increase profit by producing more units. A similar argument applies at high levels of output, such as Q2. In this case, marginal cost is greater than marginal revenue. If the firm reduced production by 1 unit, the costs saved would exceed the revenue lost. If marginal cost is greater than marginal revenue, the firm can raise profit by reducing production. In the end, the firm adjusts its level of production until the quantity reaches QMAX, at which marginal revenue equals marginal cost. The monopolist’s profit-maximizing quantity of output is determined by the intersection of the marginal revenue curve and the marginal cost curve, this inter- section occurs at point A.
Remember that competitive firms maximize profit at the quantity of output at which marginal rev- enue equals marginal cost. In following this rule for profit maximization, competitive firms and mono- polies are alike. But there is also an important difference between these types of firm: the marginal revenue of a competitive firm equals its price, whereas the marginal revenue of a monopoly is less than its price. That is:For a competitive firm: P = MR = MC For a monopoly firm: P > MR = MC
A Monopoly's Profit
How much profit does a monopoly make?
A Monopoly's Profit
To see the monopoly’s profit, recall that profit (π) equals total revenue (TR) minus total costs (TC): π = TR − TC We can rewrite this as: π = (TR/Q − TC/Q) × Q TR/Q is average revenue, which equals the price P and TC/Q is average total cost ATC. Therefore: π = (P − ATC) × Q This equation for profit (which is the same as the profit equation for competitive firms) allows us to meas- ure the monopolist’s profit in our graph. Consider the shaded box in Figure 14.5. The height of the box (the segment BC) is price minus average total cost, P − ATC , which is the profit on the typical unit sold. The width of the box (the segment DC) is the quantity sold QMAX. Therefore, the area of this box is the monopoly firm’s total profit.