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Principles of Economics

9.2 How a Profit-Maximizing Monopoly Chooses Output and Price

Principles of Economics9.2 How a Profit-Maximizing Monopoly Chooses Output and Price
  1. Preface
  2. 1 Welcome to Economics!
    1. Introduction
    2. 1.1 What Is Economics, and Why Is It Important?
    3. 1.2 Microeconomics and Macroeconomics
    4. 1.3 How Economists Use Theories and Models to Understand Economic Issues
    5. 1.4 How Economies Can Be Organized: An Overview of Economic Systems
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
  3. 2 Choice in a World of Scarcity
    1. Introduction to Choice in a World of Scarcity
    2. 2.1 How Individuals Make Choices Based on Their Budget Constraint
    3. 2.2 The Production Possibilities Frontier and Social Choices
    4. 2.3 Confronting Objections to the Economic Approach
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  4. 3 Demand and Supply
    1. Introduction to Demand and Supply
    2. 3.1 Demand, Supply, and Equilibrium in Markets for Goods and Services
    3. 3.2 Shifts in Demand and Supply for Goods and Services
    4. 3.3 Changes in Equilibrium Price and Quantity: The Four-Step Process
    5. 3.4 Price Ceilings and Price Floors
    6. 3.5 Demand, Supply, and Efficiency
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  5. 4 Labor and Financial Markets
    1. Introduction to Labor and Financial Markets
    2. 4.1 Demand and Supply at Work in Labor Markets
    3. 4.2 Demand and Supply in Financial Markets
    4. 4.3 The Market System as an Efficient Mechanism for Information
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  6. 5 Elasticity
    1. Introduction to Elasticity
    2. 5.1 Price Elasticity of Demand and Price Elasticity of Supply
    3. 5.2 Polar Cases of Elasticity and Constant Elasticity
    4. 5.3 Elasticity and Pricing
    5. 5.4 Elasticity in Areas Other Than Price
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  7. 6 Consumer Choices
    1. Introduction to Consumer Choices
    2. 6.1 Consumption Choices
    3. 6.2 How Changes in Income and Prices Affect Consumption Choices
    4. 6.3 Labor-Leisure Choices
    5. 6.4 Intertemporal Choices in Financial Capital Markets
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  8. 7 Cost and Industry Structure
    1. Introduction to Cost and Industry Structure
    2. 7.1 Explicit and Implicit Costs, and Accounting and Economic Profit
    3. 7.2 The Structure of Costs in the Short Run
    4. 7.3 The Structure of Costs in the Long Run
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  9. 8 Perfect Competition
    1. Introduction to Perfect Competition
    2. 8.1 Perfect Competition and Why It Matters
    3. 8.2 How Perfectly Competitive Firms Make Output Decisions
    4. 8.3 Entry and Exit Decisions in the Long Run
    5. 8.4 Efficiency in Perfectly Competitive Markets
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  10. 9 Monopoly
    1. Introduction to a Monopoly
    2. 9.1 How Monopolies Form: Barriers to Entry
    3. 9.2 How a Profit-Maximizing Monopoly Chooses Output and Price
    4. Key Terms
    5. Key Concepts and Summary
    6. Self-Check Questions
    7. Review Questions
    8. Critical Thinking Questions
    9. Problems
  11. 10 Monopolistic Competition and Oligopoly
    1. Introduction to Monopolistic Competition and Oligopoly
    2. 10.1 Monopolistic Competition
    3. 10.2 Oligopoly
    4. Key Terms
    5. Key Concepts and Summary
    6. Self-Check Questions
    7. Review Questions
    8. Critical Thinking Questions
    9. Problems
  12. 11 Monopoly and Antitrust Policy
    1. Introduction to Monopoly and Antitrust Policy
    2. 11.1 Corporate Mergers
    3. 11.2 Regulating Anticompetitive Behavior
    4. 11.3 Regulating Natural Monopolies
    5. 11.4 The Great Deregulation Experiment
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  13. 12 Environmental Protection and Negative Externalities
    1. Introduction to Environmental Protection and Negative Externalities
    2. 12.1 The Economics of Pollution
    3. 12.2 Command-and-Control Regulation
    4. 12.3 Market-Oriented Environmental Tools
    5. 12.4 The Benefits and Costs of U.S. Environmental Laws
    6. 12.5 International Environmental Issues
    7. 12.6 The Tradeoff between Economic Output and Environmental Protection
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
    13. Problems
  14. 13 Positive Externalities and Public Goods
    1. Introduction to Positive Externalities and Public Goods
    2. 13.1 Why the Private Sector Under Invests in Innovation
    3. 13.2 How Governments Can Encourage Innovation
    4. 13.3 Public Goods
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  15. 14 Poverty and Economic Inequality
    1. Introduction to Poverty and Economic Inequality
    2. 14.1 Drawing the Poverty Line
    3. 14.2 The Poverty Trap
    4. 14.3 The Safety Net
    5. 14.4 Income Inequality: Measurement and Causes
    6. 14.5 Government Policies to Reduce Income Inequality
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  16. 15 Issues in Labor Markets: Unions, Discrimination, Immigration
    1. Introduction to Issues in Labor Markets: Unions, Discrimination, Immigration
    2. 15.1 Unions
    3. 15.2 Employment Discrimination
    4. 15.3 Immigration
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
  17. 16 Information, Risk, and Insurance
    1. Introduction to Information, Risk, and Insurance
    2. 16.1 The Problem of Imperfect Information and Asymmetric Information
    3. 16.2 Insurance and Imperfect Information
    4. Key Terms
    5. Key Concepts and Summary
    6. Self-Check Questions
    7. Review Questions
    8. Critical Thinking Questions
    9. Problems
  18. 17 Financial Markets
    1. Introduction to Financial Markets
    2. 17.1 How Businesses Raise Financial Capital
    3. 17.2 How Households Supply Financial Capital
    4. 17.3 How to Accumulate Personal Wealth
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  19. 18 Public Economy
    1. Introduction to Public Economy
    2. 18.1 Voter Participation and Costs of Elections
    3. 18.2 Special Interest Politics
    4. 18.3 Flaws in the Democratic System of Government
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  20. 19 The Macroeconomic Perspective
    1. Introduction to the Macroeconomic Perspective
    2. 19.1 Measuring the Size of the Economy: Gross Domestic Product
    3. 19.2 Adjusting Nominal Values to Real Values
    4. 19.3 Tracking Real GDP over Time
    5. 19.4 Comparing GDP among Countries
    6. 19.5 How Well GDP Measures the Well-Being of Society
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  21. 20 Economic Growth
    1. Introduction to Economic Growth
    2. 20.1 The Relatively Recent Arrival of Economic Growth
    3. 20.2 Labor Productivity and Economic Growth
    4. 20.3 Components of Economic Growth
    5. 20.4 Economic Convergence
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  22. 21 Unemployment
    1. Introduction to Unemployment
    2. 21.1 How the Unemployment Rate is Defined and Computed
    3. 21.2 Patterns of Unemployment
    4. 21.3 What Causes Changes in Unemployment over the Short Run
    5. 21.4 What Causes Changes in Unemployment over the Long Run
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  23. 22 Inflation
    1. Introduction to Inflation
    2. 22.1 Tracking Inflation
    3. 22.2 How Changes in the Cost of Living are Measured
    4. 22.3 How the U.S. and Other Countries Experience Inflation
    5. 22.4 The Confusion Over Inflation
    6. 22.5 Indexing and Its Limitations
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  24. 23 The International Trade and Capital Flows
    1. Introduction to the International Trade and Capital Flows
    2. 23.1 Measuring Trade Balances
    3. 23.2 Trade Balances in Historical and International Context
    4. 23.3 Trade Balances and Flows of Financial Capital
    5. 23.4 The National Saving and Investment Identity
    6. 23.5 The Pros and Cons of Trade Deficits and Surpluses
    7. 23.6 The Difference between Level of Trade and the Trade Balance
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
    13. Problems
  25. 24 The Aggregate Demand/Aggregate Supply Model
    1. Introduction to the Aggregate Demand/Aggregate Supply Model
    2. 24.1 Macroeconomic Perspectives on Demand and Supply
    3. 24.2 Building a Model of Aggregate Demand and Aggregate Supply
    4. 24.3 Shifts in Aggregate Supply
    5. 24.4 Shifts in Aggregate Demand
    6. 24.5 How the AD/AS Model Incorporates Growth, Unemployment, and Inflation
    7. 24.6 Keynes’ Law and Say’s Law in the AD/AS Model
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
    13. Problems
  26. 25 The Keynesian Perspective
    1. Introduction to the Keynesian Perspective
    2. 25.1 Aggregate Demand in Keynesian Analysis
    3. 25.2 The Building Blocks of Keynesian Analysis
    4. 25.3 The Phillips Curve
    5. 25.4 The Keynesian Perspective on Market Forces
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
  27. 26 The Neoclassical Perspective
    1. Introduction to the Neoclassical Perspective
    2. 26.1 The Building Blocks of Neoclassical Analysis
    3. 26.2 The Policy Implications of the Neoclassical Perspective
    4. 26.3 Balancing Keynesian and Neoclassical Models
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  28. 27 Money and Banking
    1. Introduction to Money and Banking
    2. 27.1 Defining Money by Its Functions
    3. 27.2 Measuring Money: Currency, M1, and M2
    4. 27.3 The Role of Banks
    5. 27.4 How Banks Create Money
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  29. 28 Monetary Policy and Bank Regulation
    1. Introduction to Monetary Policy and Bank Regulation
    2. 28.1 The Federal Reserve Banking System and Central Banks
    3. 28.2 Bank Regulation
    4. 28.3 How a Central Bank Executes Monetary Policy
    5. 28.4 Monetary Policy and Economic Outcomes
    6. 28.5 Pitfalls for Monetary Policy
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  30. 29 Exchange Rates and International Capital Flows
    1. Introduction to Exchange Rates and International Capital Flows
    2. 29.1 How the Foreign Exchange Market Works
    3. 29.2 Demand and Supply Shifts in Foreign Exchange Markets
    4. 29.3 Macroeconomic Effects of Exchange Rates
    5. 29.4 Exchange Rate Policies
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  31. 30 Government Budgets and Fiscal Policy
    1. Introduction to Government Budgets and Fiscal Policy
    2. 30.1 Government Spending
    3. 30.2 Taxation
    4. 30.3 Federal Deficits and the National Debt
    5. 30.4 Using Fiscal Policy to Fight Recession, Unemployment, and Inflation
    6. 30.5 Automatic Stabilizers
    7. 30.6 Practical Problems with Discretionary Fiscal Policy
    8. 30.7 The Question of a Balanced Budget
    9. Key Terms
    10. Key Concepts and Summary
    11. Self-Check Questions
    12. Review Questions
    13. Critical Thinking Questions
    14. Problems
  32. 31 The Impacts of Government Borrowing
    1. Introduction to the Impacts of Government Borrowing
    2. 31.1 How Government Borrowing Affects Investment and the Trade Balance
    3. 31.2 Fiscal Policy, Investment, and Economic Growth
    4. 31.3 How Government Borrowing Affects Private Saving
    5. 31.4 Fiscal Policy and the Trade Balance
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  33. 32 Macroeconomic Policy Around the World
    1. Introduction to Macroeconomic Policy around the World
    2. 32.1 The Diversity of Countries and Economies across the World
    3. 32.2 Improving Countries’ Standards of Living
    4. 32.3 Causes of Unemployment around the World
    5. 32.4 Causes of Inflation in Various Countries and Regions
    6. 32.5 Balance of Trade Concerns
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  34. 33 International Trade
    1. Introduction to International Trade
    2. 33.1 Absolute and Comparative Advantage
    3. 33.2 What Happens When a Country Has an Absolute Advantage in All Goods
    4. 33.3 Intra-industry Trade between Similar Economies
    5. 33.4 The Benefits of Reducing Barriers to International Trade
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  35. 34 Globalization and Protectionism
    1. Introduction to Globalization and Protectionism
    2. 34.1 Protectionism: An Indirect Subsidy from Consumers to Producers
    3. 34.2 International Trade and Its Effects on Jobs, Wages, and Working Conditions
    4. 34.3 Arguments in Support of Restricting Imports
    5. 34.4 How Trade Policy Is Enacted: Globally, Regionally, and Nationally
    6. 34.5 The Tradeoffs of Trade Policy
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  36. A | The Use of Mathematics in Principles of Economics
  37. B | Indifference Curves
  38. C | Present Discounted Value
  39. The Expenditure-Output Model
  40. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
    14. Chapter 14
    15. Chapter 15
    16. Chapter 16
    17. Chapter 17
    18. Chapter 18
    19. Chapter 19
    20. Chapter 20
    21. Chapter 21
    22. Chapter 22
    23. Chapter 23
    24. Chapter 24
    25. Chapter 25
    26. Chapter 26
    27. Chapter 27
    28. Chapter 28
    29. Chapter 29
    30. Chapter 30
    31. Chapter 31
    32. Chapter 32
    33. Chapter 33
    34. Chapter 34
  41. References
  42. Index

By the end of this section, you will be able to:

  • Explain the perceived demand curve for a perfect competitor and a monopoly
  • Analyze a demand curve for a monopoly and determine the output that maximizes profit and revenue
  • Calculate marginal revenue and marginal cost
  • Explain allocative efficiency as it pertains to the efficiency of a monopoly

Consider a monopoly firm, comfortably surrounded by barriers to entry so that it need not fear competition from other producers. How will this monopoly choose its profit-maximizing quantity of output, and what price will it charge? Profits for the monopolist, like any firm, will be equal to total revenues minus total costs. The pattern of costs for the monopoly can be analyzed within the same framework as the costs of a perfectly competitive firm—that is, by using total cost, fixed cost, variable cost, marginal cost, average cost, and average variable cost. However, because a monopoly faces no competition, its situation and its decision process will differ from that of a perfectly competitive firm. (The Clear it Up feature discusses how hard it is sometimes to define “market” in a monopoly situation.)

Demand Curves Perceived by a Perfectly Competitive Firm and by a Monopoly

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 9.3 (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.

The left graph shows perceived demand for a perfect competitor as a straight, horizontal line. The right graph shows perceived demand for a monopolist as a downward-sloping curve.
Figure 9.3 The Perceived Demand Curve for a Perfect Competitor and a Monopolist (a) A perfectly competitive firm perceives the demand curve that it faces to be flat. The flat shape means that the firm can sell either a low quantity (Ql) or a high quantity (Qh) at exactly the same price (P). (b) A monopolist perceives the demand curve that it faces to be the same as the market demand curve, which for most goods is downward-sloping. Thus, if the monopolist chooses a high level of output (Qh), it can charge only a relatively low price (Pl); conversely, if the monopolist chooses a low level of output (Ql), it can then charge a higher price (Ph). The challenge for the monopolist is to choose the combination of price and quantity that maximizes profits.

Clear It Up

What defines the market?

A monopoly is a firm that sells all or nearly all of the goods and services in a given market. But what defines the “market”?

In a famous 1947 case, the federal government accused the DuPont company of having a monopoly in the cellophane market, pointing out that DuPont produced 75% of the cellophane in the United States. DuPont countered that even though it had a 75% market share in cellophane, it had less than a 20% share of the “flexible packaging materials,” which includes all other moisture-proof papers, films, and foils. In 1956, after years of legal appeals, the U.S. 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. True, Microsoft in the 1990s had a dominant share of the software for computer operating systems, but in the total market for all computer software and services, including everything from games to scientific programs, the Microsoft share was only about 14% in 2014. 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. A small town in the country may have only one gas station: is this gas station a “monopoly,” or does it compete with gas stations that might be five, 10, or 50 miles away?

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.

While a monopolist can charge any price for its product, that price is nonetheless constrained by demand for the firm’s product. 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 9.3 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. But why isn’t the perfectly competitive firm’s demand curve also the market demand curve? See the following Clear it Up feature for the answer to this question.

Clear It Up

What is the difference between perceived demand and market demand?

The demand curve as perceived by a perfectly competitive firm is not the overall market demand curve for that product. However, the firm’s demand curve as perceived by a monopoly is the same as the market demand curve. 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.

Total Cost and Total Revenue for a Monopolist

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 9.4. The total cost curve has its typical shape; that is, total costs rise and the curve grows steeper as output increases.

The graph shows total cost as an upward-sloping line and total revenue as a curve that rises then falls. The two curves intersect at two different points.
Figure 9.4 Total Revenue and Total Cost for the HealthPill Monopoly Total revenue for the monopoly firm called HealthPill first rises, then falls. Low levels of output bring in relatively little total revenue, because the quantity is low. High levels of output bring in relatively less revenue, because the high quantity pushes down the market price. The total cost curve is upward-sloping. Profits will be highest at the quantity of output where total revenue is most above total cost. Of the choices in Table 9.2, the highest profits happen at an output of 4. The profit-maximizing level of output is not the same as the revenue-maximizing level of output, which should make sense, because profits take costs into account and revenues do not.
Quantity Total Cost Quantity Price Total Revenue Profit = Total Revenue – Total Cost
1 1,500 1 1,200 1,200 –300
2 1,800 2 1,100 2,200 400
3 2,200 3 1,000 3,000 800
4 2,800 4 900 3,600 800
5 3,500 5 800 4,000 500
6 4,200 6 700 4,200 0
7 5,600 7 600 4,200 –1,400
8 7,400 8 500 4,000 –3,400
Table 9.2 Total Costs and Total Revenues of HealthPill

To calculate total revenue for a monopolist, start with the demand curve perceived by the monopolist. Table 9.2 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 1,000 or 10,000 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. 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.

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 9.4, 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 800.

Marginal Revenue and Marginal Cost for a Monopolist

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 9.3 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 9.5. The second four columns of Table 9.3 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.

The graph shows marginal cost as an upward-sloping curve and marginal revenue as a downward-sloping line. Where the two lines intersect is where maximum profit is possible.
Figure 9.5 Marginal Revenue and Marginal Cost for the HealthPill Monopoly For a monopoly like HealthPill, marginal revenue decreases as additional units are sold. The marginal cost curve is upward-sloping. The profit-maximizing choice for the monopoly will be to produce at the quantity where marginal revenue is equal to marginal cost: that is, MR = MC. If the monopoly produces a lower quantity, then MR > MC at those levels of output, and the firm can make higher profits by expanding output. If the firm produces at a greater quantity, then MC > MR, and the firm can make higher profits by reducing its quantity of output.
Cost Information Revenue Information
Quantity Total Cost Marginal Cost Average Cost Quantity Price Total Revenue Marginal Revenue
1 1,500 1,500 1,500 1 1,200 1,200 1,200
2 1,800 300 900 2 1,100 2,200 1,000
3 2,200 400 733 3 1,000 3,000 800
4 2,800 600 700 4 900 3,600 600
5 3,500 700 700 5 800 4,000 400
6 4,200 700 700 6 700 4,200 200
7 5,600 1,400 800 7 600 4,200 0
8 7,400 1,800 925 8 500 4,000 –200
Table 9.3 Costs and Revenues of HealthPill

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 9.5, marginal revenue is 800 and marginal cost is 400, so producing this unit will clearly add to overall profits. At an output of 4, marginal revenue is 600 and marginal cost is 600, so producing this unit still means overall profits are unchanged. However, expanding output from 4 to 5 would involve a marginal revenue of 400 and a marginal cost of 700, 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. Thus, a profit-maximizing monopoly should follow the rule of producing up to the quantity where marginal revenue is equal to marginal cost—that is, MR = MC.

Work It Out

Maximizing Profits

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.

MC=change in total costchange in quantity producedMC=change in total costchange in quantity produced

Step 2. Note that in Table 9.3, as output increases from 1 to 2 units, total cost increases from $1500 to $1800. As a result, the marginal cost of the second unit will be:

MC=$1800$15001=$300MC=$1800$15001=$300

Step 3. Remember that, similarly, marginal revenue is the change in total revenue from selling a small amount of additional output.

MR=change in total revenuechange in quantity soldMR=change in total revenuechange in quantity sold

Step 4. Note that in Table 9.3, as output increases from 1 to 2 units, total revenue increases from $1200 to $2200. As a result, the marginal revenue of the second unit will be:

MR=$2200$12001=$1000MR=$2200$12001=$1000
Quantity Marginal Revenue Marginal Cost Marginal Profit Total Profit
1 1,200 1,500 –300 –300
2 1,000 300 700 400
3 800 400 400 800
4 600 600 0 800
5 400 700 –300 500
6 200 700 –500 0
7 0 1,400 –1,400 –1,400
Table 9.4 Marginal Revenue, Marginal Cost, Marginal and Total Profit

Table 9.4 repeats the marginal cost and marginal revenue data from Table 9.3, and adds two more columns: Marginal profit is the profitability of each additional unit sold. It is defined 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 4 units of output.

A perfectly competitive firm will also find its profit-maximizing level of output where MR = MC. The key difference with a perfectly competitive firm is that in the case of perfect competition, marginal revenue is equal to price (MR = P), while for a monopolist, marginal revenue is not equal to the price, because changes in quantity of output affect the price.

Illustrating Monopoly Profits

It is straightforward to calculate profits of given numbers for total revenue and total cost. However, the size of monopoly profits can also be illustrated graphically with Figure 9.6, which takes the marginal cost and marginal revenue curves from the previous exhibit and adds an average cost curve and the monopolist’s perceived demand curve.

The graph shows revenues and profits for the monopolist at the profit maximizing level of output.
Figure 9.6 Illustrating Profits at the HealthPill Monopoly This figure begins with the same marginal revenue and marginal cost curves from the HealthPill monopoly presented in Figure 9.5. It then adds an average cost curve and the demand curve faced by the monopolist. The HealthPill firm first chooses the quantity where MR = MC; in this example, the quantity is 4. The monopolist then decides what price to charge by looking at the demand curve it faces. The large box, with quantity on the horizontal axis and marginal revenue on the vertical axis, shows total revenue for the firm. Total costs for the firm are shown by the lighter-shaded box, which is quantity on the horizontal axis and marginal cost of production on the vertical axis. The large total revenue box minus the smaller total cost box leaves the darkly shaded box that shows total profits. Since the price charged is above average cost, the firm is earning positive profits.

Figure 9.7 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.

Step 1: The Monopolist Determines Its Profit-Maximizing Level of Output

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 profit-maximizing quantity will occur where MR = MC—or at the last possible point before marginal costs start exceeding marginal revenue. On Figure 9.6, MR = MC occurs at an output of 4.

Step 2: The Monopolist Decides What Price to Charge

The monopolist will charge what the market is willing to pay. A dotted line drawn straight up from the profit-maximizing quantity to the demand curve shows the profit-maximizing price. This price is above the average cost curve, which shows that the firm is earning profits.

Step 3: Calculate Total Revenue, Total Cost, and Profit

Total revenue is the overall shaded box, where the width of the box is the quantity being sold and the height is the price. In Figure 9.6, the bottom part of the shaded box, which is shaded more lightly, shows total costs; that is, quantity on the horizontal axis multiplied by average cost on the vertical axis. The larger box of total revenues minus the smaller box of total costs will equal profits, which is shown by the darkly shaded box. In a perfectly competitive market, the forces of entry would erode this profit in the long run. But a monopolist is protected by barriers to entry. In fact, one telltale 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 those profits eroded by increased competition.

 The graph shows monopoly profits as the area between the demand curve and the average cost curve at the monopolist’s level of output.
Figure 9.7 How a Profit-Maximizing Monopoly Decides Price In Step 1, the monopoly chooses the profit-maximizing level of output Q1, by choosing the quantity where MR = MC. In Step 2, the monopoly decides how much to charge for output level Q1 by drawing a line straight up from Q1 to point R on its perceived demand curve. Thus, the monopoly will charge a price (P1). In Step 3, the monopoly identifies its profit. Total revenue will be Q1 multiplied by P1. Total cost will be Q1 multiplied by the average cost of producing Q1, which is shown by point S on the average cost curve to be P2. Profits will be the total revenue rectangle minus the total cost rectangle, shown by the shaded zone in the figure.

Clear It Up

Why is a monopolist’s marginal revenue always less than the price?

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 Q1 at a higher price, and then we sell Q2 at a lower price. Rather, a demand curve is conditional: If we charge the higher price, we would sell Q1. If, instead, we charge a lower price (on all the units that we sell), we would sell Q2.

So 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 could have been 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. 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 9.8.

The graph shows that the market demand curve is conditional, so the marginal revenue curve for a monopolist lies beneath the demand curve.
Figure 9.8 The Monopolist’s Marginal Revenue Curve versus Demand Curve Because the market demand curve is conditional, the marginal revenue curve for a monopolist lies beneath the demand curve.

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 a social concept. 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. The rule of profit maximization in a world of perfect competition was for each firm to produce the quantity of output where P = MC, where the price (P) is a measure of how much buyers value the good and the marginal cost (MC) is a measure of what marginal units cost society to produce. Following this rule assures allocative efficiency. If P > MC, then the marginal benefit to society (as measured by P) is greater than the marginal cost to society of producing additional units, and a greater quantity should be produced. But in the case of monopoly, price is always greater than marginal cost at the profit-maximizing level of output, as can be seen by looking back at Figure 9.6. Thus, consumers will suffer from a monopoly because a lower quantity will be sold 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. John Hicks, who won the Nobel Prize for economics in 1972, wrote in 1935: “The best of all monopoly profits is a quiet life.” He did not mean the comment in a complimentary way. He meant that monopolies may bank their profits and slack off on trying to please their customers.

When AT&T provided all of the local and long-distance phone service in the United States, along with manufacturing most of the phone equipment, the payment plans and types of phones did not change much. The old joke was that you could have any color phone you wanted, as long as it was black. But in 1982, AT&T was split up by government litigation into a number of local phone companies, a long-distance phone company, and a phone equipment manufacturer. An explosion of innovation followed. Services like call waiting, caller ID, three-way calling, voice mail though the phone company, mobile phones, and wireless connections to the Internet all became available. A wide range of payment plans was offered, 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.

Bring It Home

The Rest is History

In the opening case, the East India Company and the Confederate States were presented as a monopoly or near monopoly provider of a good. Nearly every American schoolchild knows the result of the ‘unwelcome visit’ the ‘Mohawks’ bestowed upon Boston Harbor’s tea-bearing ships—the Boston Tea Party. 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? Might the southern states have made different decisions had they not been so confident “King Cotton” would force diplomatic recognition of the Confederate States of America? Of course, it is not possible to definitively answer these questions; after all 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 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 1862. 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 1833, 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? Perhaps. But, as they say, the rest is history.

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