However, because a monopoly faces no competition, its situation and its decision process will differ from that of a perfectly competitive firm. A perfectly competitive firm acts as a price taker, so its calculation of total revenue is made by taking the given market price and multiplying it by the quantity of output that the firm chooses.
The demand curve as it is perceived by a perfectly competitive firm appears in Figure 1 a. The flat perceived demand curve means that, from the viewpoint of the perfectly competitive firm, it could sell either a relatively low quantity like Ql or a relatively high quantity like Qh at the market price P. A monopoly is a firm that sells all or nearly all of the goods and services in a given market. In , after years of legal appeals, the U. Supreme Court held that the broader market definition was more appropriate, and the case against DuPont was dismissed.
Questions over how to define the market continue today. The Greyhound bus company may have a near-monopoly on the market for intercity bus transportation, but it is only a small share of the market for intercity transportation if that market includes private cars, airplanes, and railroad service. DeBeers has a monopoly in diamonds, but it is a much smaller share of the total market for precious gemstones and an even smaller share of the total market for jewelry.
Marginal Revenue, Price and Total Revenue
In general, if a firm produces a product without close substitutes, then the firm can be considered a monopoly producer in a single market. But if buyers have a range of similar—even if not identical—options available from other firms, then the firm is not a monopoly. Still, arguments over whether substitutes are close or not close can be controversial. No monopolist, even one that is thoroughly protected by high barriers to entry, can require consumers to purchase its product.
Because the monopolist is the only firm in the market, its demand curve is the same as the market demand curve, which is, unlike that for a perfectly competitive firm, downward-sloping. Figure 1 illustrates this situation. The monopolist can either choose a point like R with a low price Pl and high quantity Qh , or a point like S with a high price Ph and a low quantity Ql , or some intermediate point.
Setting the price too high will result in a low quantity sold, and will not bring in much revenue. Conversely, setting the price too low may result in a high quantity sold, but because of the low price, it will not bring in much revenue either. The challenge for the monopolist is to strike a profit-maximizing balance between the price it charges and the quantity that it sells.
See the following Clear it Up feature for the answer to this question. The demand curve as perceived by a perfectly competitive firm is not the overall market demand curve for that product. The reason for the difference is that each perfectly competitive firm perceives the demand for its products in a market that includes many other firms; in effect, the demand curve perceived by a perfectly competitive firm is a tiny slice of the entire market demand curve.
In contrast, a monopoly perceives demand for its product in a market where the monopoly is the only producer. Profits for a monopolist can be illustrated with a graph of total revenues and total costs, as shown with the example of the hypothetical HealthPill firm in Figure 2. The total cost curve has its typical shape; that is, total costs rise and the curve grows steeper as output increases. To calculate total revenue for a monopolist, start with the demand curve perceived by the monopolist. Table 2 shows quantities along the demand curve and the price at each quantity demanded, and then calculates total revenue by multiplying price times quantity at each level of output.
In this example, the output is given as 1, 2, 3, 4, and so on, for the sake of simplicity. If you prefer a dash of greater realism, you can imagine that these output levels and the corresponding prices are measured per 1, or 10, pills. As the figure illustrates, total revenue for a monopolist rises, flattens out, and then falls. In this example, total revenue is highest at a quantity of 6 or 7. Clearly, the total revenue for a monopolist is not a straight upward-sloping line, in the way that total revenue was for a perfectly competitive firm.
Market Differences Between Monopoly and Perfect Competition
The different total revenue pattern for a monopolist occurs because the quantity that a monopolist chooses to produce affects the market price, which was not true for a perfectly competitive firm. If the monopolist charges a very high price, then quantity demanded drops, and so total revenue is very low. If the monopolist charges a very low price, then, even if quantity demanded is very high, total revenue will not add up to much. At some intermediate level, total revenue will be highest.
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However, the monopolist is not seeking to maximize revenue, but instead to earn the highest possible profit. Profits are calculated in the final row of the table. In the HealthPill example in Figure 2 , the highest profit will occur at the quantity where total revenue is the farthest above total cost. Of the choices given in the table, the highest profits occur at an output of 4, where profit is In the real world, a monopolist often does not have enough information to analyze its entire total revenues or total costs curves; after all, the firm does not know exactly what would happen if it were to alter production dramatically.
But a monopolist often has fairly reliable information about how changing output by small or moderate amounts will affect its marginal revenues and marginal costs, because it has had experience with such changes over time and because modest changes are easier to extrapolate from current experience.
A monopolist can use information on marginal revenue and marginal cost to seek out the profit-maximizing combination of quantity and price. The first four columns of Table 3 use the numbers on total cost from the HealthPill example in the previous exhibit and calculate marginal cost and average cost. This monopoly faces a typical upward-sloping marginal cost curve, as shown in Figure 3.
The second four columns of Table 3 use the total revenue information from the previous exhibit and calculate marginal revenue. Notice that marginal revenue is zero at a quantity of 7, and turns negative at quantities higher than 7. It may seem counterintuitive that marginal revenue could ever be zero or negative: after all, does an increase in quantity sold not always mean more revenue?
For a perfect competitor, each additional unit sold brought a positive marginal revenue, because marginal revenue was equal to the given market price. But a monopolist can sell a larger quantity and see a decline in total revenue. When a monopolist increases sales by one unit, it gains some marginal revenue from selling that extra unit, but also loses some marginal revenue because every other unit must now be sold at a lower price.
As the quantity sold becomes higher, the drop in price affects a greater quantity of sales, eventually causing a situation where more sales cause marginal revenue to be negative. A monopolist can determine its profit-maximizing price and quantity by analyzing the marginal revenue and marginal costs of producing an extra unit. If the marginal revenue exceeds the marginal cost, then the firm should produce the extra unit. For example, at an output of 3 in Figure 3 , marginal revenue is and marginal cost is , so producing this unit will clearly add to overall profits.
At an output of 4, marginal revenue is and marginal cost is , so producing this unit still means overall profits are unchanged.
Monopoly Price and Output | Profit Maximization | Example
However, expanding output from 4 to 5 would involve a marginal revenue of and a marginal cost of , so that fifth unit would actually reduce profits. Thus, the monopoly can tell from the marginal revenue and marginal cost that of the choices given in the table, the profit-maximizing level of output is 4. Indeed, the monopoly could seek out the profit-maximizing level of output by increasing quantity by a small amount, calculating marginal revenue and marginal cost, and then either increasing output as long as marginal revenue exceeds marginal cost or reducing output if marginal cost exceeds marginal revenue.
This process works without any need to calculate total revenue and total cost. If you find it counterintuitive that producing where marginal revenue equals marginal cost will maximize profits, working through the numbers will help. Step 1. Remember that marginal cost is defined as the change in total cost from producing a small amount of additional output. Step 2. As a result, the marginal cost of the second unit will be:.
Monopoly Price and Output
Step 3. Remember that, similarly, marginal revenue is the change in total revenue from selling a small amount of additional output. Step 4. As a result, the marginal revenue of the second unit will be:. This is changing fast as the industry seen fresh competition. The Royal Mail was part-privatised in Subscribe to email updates from tutor2u Economics Join s of fellow Economics teachers and students all getting the tutor2u Economics team's latest resources and support delivered fresh in their inbox every morning.
You're now subscribed to receive email updates! Print page. Related Collections. Monopoly Power Collections. You might also like. Challenger Banks Financial Economics Study notes. Advantages and Disadvantages of Monopoly Power Student videos. Normal and Abnormal Profit Student videos. Barriers to Entry and Exit Study notes. Explaining Natural Monopoly Study notes. Contestable Markets Chain of Analysis Student videos.
Behavioural Theories of the Firm Study notes. Natural Monopoly Chain of Analysis Student videos. Why do businesses grow? Study notes. Monopoly Power Quizlet Activity Revision quizzes. If you find it counterintuitive that producing where marginal revenue equals marginal cost will maximize profits, working through the numbers will help.
Step 1. Remember, we define marginal cost as the change in total cost from producing a small amount of additional output. Step 2. As a result, the marginal cost of the second unit will be:. Step 3. Remember that, similarly, marginal revenue is the change in total revenue from selling a small amount of additional output. Step 4. As a result, the marginal revenue of the second unit will be:.
Figure repeats the marginal cost and marginal revenue data from Figure , and adds two more columns: Marginal profit is the profitability of each additional unit sold. We define it as marginal revenue minus marginal cost. Finally, total profit is the sum of marginal profits. As long as marginal profit is positive, producing more output will increase total profits. When marginal profit turns negative, producing more output will decrease total profits. Total profit is maximized where marginal revenue equals marginal cost.
In this example, maximum profit occurs at 5 units of output. It is straightforward to calculate profits of given numbers for total revenue and total cost. Figure shows the data for these curves. Figure illustrates the three-step process where a monopolist: selects the profit-maximizing quantity to produce; decides what price to charge; determines total revenue, total cost, and profit.
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The firm can use the points on the demand curve D to calculate total revenue, and then, based on total revenue, calculate its marginal revenue curve. The monopolist will charge what the market is willing to pay. This price is above the average cost curve, which shows that the firm is earning profits. Total revenue is the overall shaded box, where the width of the box is the quantity sold and the height is the price.
The larger box of total revenues minus the smaller box of total costs will equal profits, which the darkly shaded box shows. In a perfectly competitive market, the forces of entry would erode this profit in the long run. However, a monopolist is protected by barriers to entry. In fact, one obvious sign of a possible monopoly is when a firm earns profits year after year, while doing more or less the same thing, without ever seeing increased competition eroding those profits.
The marginal revenue curve for a monopolist always lies beneath the market demand curve. To understand why, think about increasing the quantity along the demand curve by one unit, so that you take one step down the demand curve to a slightly higher quantity but a slightly lower price. A demand curve is not sequential: It is not that first we sell Q 1 at a higher price, and then we sell Q 2 at a lower price.
Rather, a demand curve is conditional: If we charge the higher price, we would sell Q 1. If, instead, we charge a lower price on all the units that we sell , we would sell Q 2. When we think about increasing the quantity sold by one unit, marginal revenue is affected in two ways. First, we sell one additional unit at the new market price. Second, all the previous units, which we sold at the higher price, now sell for less.
Because of the lower price on all units sold, the marginal revenue of selling a unit is less than the price of that unit—and the marginal revenue curve is below the demand curve.
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Tip : For a straight-line demand curve, MR and demand have the same vertical intercept. As output increases, marginal revenue decreases twice as fast as demand, so that the horizontal intercept of MR is halfway to the horizontal intercept of demand. You can see this in the Figure. The Inefficiency of Monopoly Most people criticize monopolies because they charge too high a price, but what economists object to is that monopolies do not supply enough output to be allocatively efficient.
To understand why a monopoly is inefficient, it is useful to compare it with the benchmark model of perfect competition. Allocative efficiency is an economic concept regarding efficiency at the social or societal level. It refers to producing the optimal quantity of some output, the quantity where the marginal benefit to society of one more unit just equals the marginal cost.
Following this rule assures allocative efficiency. However, in the case of monopoly, price is always greater than marginal cost at the profit-maximizing level of output, as you can see by looking back at Figure. Thus, consumers will suffer from a monopoly because it will sell a lower quantity in the market, at a higher price, than would have been the case in a perfectly competitive market. The problem of inefficiency for monopolies often runs even deeper than these issues, and also involves incentives for efficiency over longer periods of time.
There are counterbalancing incentives here. On one side, firms may strive for new inventions and new intellectual property because they want to become monopolies and earn high profits—at least for a few years until the competition catches up. In this way, monopolies may come to exist because of competitive pressures on firms. However, once a barrier to entry is in place, a monopoly that does not need to fear competition can just produce the same old products in the same old way—while still ringing up a healthy rate of profit.
He meant that monopolies may bank their profits and slack off on trying to please their customers. The old joke was that you could have any color phone you wanted, as long as it was black. An explosion of innovation followed. Services like call waiting, caller ID, three-way calling, voice mail through the phone company, mobile phones, and wireless connections to the internet all became available. Companies offered a wide range of payment plans, as well. It was no longer true that all phones were black.
Instead, phones came in a wide variety of shapes and colors. The end of the telephone monopoly brought lower prices, a greater quantity of services, and also a wave of innovation aimed at attracting and pleasing customers. In the opening case, we presented the East India Company and the Confederate States as a monopoly or near monopoly provider of a good. Regarding the cotton industry, we also know Great Britain remained neutral during the Civil War, taking neither side during the conflict. Did the monopoly nature of these business have unintended and historical consequences?
Might the American Revolution have been deterred, if the East India Company had sailed the tea-bearing ships back to England?
How does a Monopolist Determine Price and Output?
Of course, it is not possible to definitively answer these questions. We cannot roll back the clock and try a different scenario. We can, however, consider the monopoly nature of these businesses and the roles they played and hypothesize about what might have occurred under different circumstances. Perhaps if there had been legal free tea trade, the colonists would have seen things differently. There was smuggled Dutch tea in the colonial market. If the colonists had been able to freely purchase Dutch tea, they would have paid lower prices and avoided the tax.
What about the cotton monopoly? With one in five jobs in Great Britain depending on Southern cotton and the Confederate States as nearly the sole provider of that cotton, why did Great Britain remain neutral during the Civil War? At the beginning of the war, Britain simply drew down massive stores of cotton. These stockpiles lasted until near the end of Why did Britain not recognize the Confederacy at that point? Two reasons: The Emancipation Proclamation and new sources of cotton. Having outlawed slavery throughout the United Kingdom in , it was politically impossible for Great Britain, empty cotton warehouses or not, to recognize, diplomatically, the Confederate States.
In addition, during the two years it took to draw down the stockpiles, Britain expanded cotton imports from India, Egypt, and Brazil. Monopoly sellers often see no threats to their superior marketplace position. In these examples did the power of the monopoly blind the decision makers to other possibilities?