Learning Objectives

• 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

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.

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.

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. 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.

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, where total costs rise and the curve grows steeper as output increases.

Figure 9.4 Total Revenue and Total Cost for the HealthPill Monopoly Total revenue for the monopoly firm 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 four. 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.

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 table illustrates, total revenue for a monopolist rises, flattens out, and then falls. In this example, total revenue is highest at a quantity of six or seven.

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 four, where profit is $900.

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 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 seven, and turns negative at quantities higher than seven. 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 creating a situation where more sales cause marginal revenue to be negative.

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.

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 three 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 four, marginal revenue is $600 and marginal cost is $600; so, producing this unit still means overall profits are unchanged. However, expanding output from four to five 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 four.

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.

Table 9.4 repeats the marginal cost and marginal revenue data from Table 9.3, and adds two more columns: marginal profit and total profit. 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 four 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, where 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.

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 four. 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; and 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. In Figure 9.6, MR = MC occurs at an output of four.

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 lightly shaded, shows total costs; that is, quantity on the horizontal axis is 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.

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.

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.

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, 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 in 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 a phone company provided all of the local and long-distance phone service in the United States, and manufactured 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, the company 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 through 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 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.