PROFIT MAXIMIZATION

Now that we have considered the revenue of a monopoly firm, we are ready to examine how such a firm maximizes profit. Recall from Chapter 1 that one of the Ten Principles of Economics is that rational people think at the margin. This lesson is as true for monopolists as it is for competitive firms. Here we apply the logic of marginal analysis to the monopolist’s decision about how much to produce.

Figure 4 graphs the demand curve, the marginal-revenue curve, and the cost curves for a monopoly firm. All these curves should seem familiar: The demand and marginal-revenue curves are like those in Figure 3, and the cost curves are like those we encountered in the last two chapters. These curves contain all the information we need to determine the level of output that a profit-maximizing monopolist will choose.

Figure 4 Profit Maximization for a Monopoly

Suppose, first, that the firm is producing at a low level of output, such as QI. 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. Thus, when marginal cost is less than marginal revenue, the firm can increase profit by producing more units.
You might recall from the previous chapter that competitive firms also choose the quantity of output at which marginal revenue equals marginal cost. In following this rule for profit maximization, competitive firms and monopolies are alike. But there is also an important difference between these types of firms: The marginal revenue of a competitive firm equals its price, whereas the marginal revenue of a monopoly is less than its price. That is

The equality of marginal revenue and marginal cost at the profit-maximizing quantity is the same for both types of firm. What differs is the relationship of the price to marginal revenue and marginal cost.

How does the monopoly find the profit-maximizing price for its product? The demand curve answers this question because the demand curve relates the amount that customers are willing to pay to the quantity sold. Thus, after the monopoly firm chooses the quantity of output that equates marginal revenue and marginal cost, it uses the demand curve to find the price consistent with that quantity. In Figure 4, the profit-maximizing price is found at point B.

We can now see a key difference between markets with competitive firms and markets with a monopoly firm: In competitive markets. price equals marginal cost. In monopolized markets. price exceeds marginal cost. As we will in a moment, this finding is crucial to understanding the social cost of monopoly.

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