Managerial Economics - Monopoly

A monopoly is a market structure characterized by a single seller or producer of a good or service for which there is no close substitute. The monopoly firm is in a position of market power, which allows it to set prices higher than its marginal cost and earn profits in the long run. The key characteristics of a monopoly firm are:

• Single seller: The monopoly firm is the only supplier of the good or service in the market.
• No close substitutes: The good or service produced by the monopoly firm has no close substitutes, meaning that consumers have no other options but to buy from the monopoly firm.
• High barriers to entry: There are significant barriers to entry for new firms to enter the market, such as high start-up costs, government regulations, or exclusive access to key resources.
• Market power: The monopoly firm has significant market power, which allows it to set prices higher than its marginal cost and earn economic profits in the long run.
• Price maker: The monopoly firm is a price maker, meaning that it can set the price of its product based on its own production and pricing decisions.
• Downward sloping demand curve: The demand curve faced by the monopoly firm is downward sloping, meaning that as the monopoly firm increases its price, the quantity demanded by consumers decreases.
• Monopoly profits: The monopoly firm can earn economic profits in the long run, as it sets its price higher than its marginal cost.

An example of a monopoly firm is the electric company that provides electricity to a particular region. The electric company has exclusive access to the power grid and transmission lines, making it difficult for new firms to enter the market. Consumers have no other options but to buy electricity from the electric company, allowing it to set prices higher than its marginal cost and earn economic profits in the long run.

Demand Curve, Total Revenue Curve and Marginal Revenue Curve of Monopoly Firm

In a monopoly market, there is only one firm that sells a unique product that has no close substitutes. As a result, the firm has considerable market power and can influence the price of the product by controlling the quantity supplied.

Demand Curve of Monopoly Firm

The demand curve faced by a monopoly firm is downward sloping, which means that as the price of the product increases, the quantity demanded decreases. The demand curve is also the average revenue (AR) curve for the firm, since the price is the same for all units of the product sold.

Total Revenue Curve of Monopoly Firm

The total revenue (TR) curve for a monopoly firm is upward sloping because the price of the product is greater than the marginal cost of production. Initially, as the firm increases the quantity of the product supplied, the total revenue also increases. However, at some point, the total revenue starts to decrease because the increase in quantity is offset by the decrease in price.

Marginal Revenue Curve of Monopoly Firm

The marginal revenue (MR) curve for a monopoly firm is downward sloping, which means that as the firm increases the quantity of the product supplied, the marginal revenue decreases. This is because the firm must lower the price of the product to sell more units, which reduces the revenue earned on each additional unit sold.

Example:

Example of the demand, total revenue, and marginal revenue curves for a monopoly firm:

Let's say the monopoly is the only provider of a certain medication, and the market demand for the medication can be represented by the following table:

To maximize profits, the monopoly firm will want to set its output level where marginal revenue (MR) equals marginal cost (MC). In this example, let's say that the marginal cost of producing each unit of medication is $10.

To determine the marginal revenue curve, we need to first determine the total revenue (TR) at each output level. Since the monopoly is the only provider of the medication, its total revenue will be the product of the price per unit and the quantity sold. This is shown in the table below:

We can see that as the quantity sold increases, the price per unit must decrease in order to sell more units. This means that the marginal revenue is less than the price per unit, and the marginal revenue curve is downward sloping.

The demand curve faced by the monopoly is the same as the market demand curve, since it is the only provider of the medication. The total revenue curve is simply a linear function that starts at $0 when quantity is 0, and increases as quantity increases, at a decreasing rate.

The relationship between the demand curve, total revenue curve, and marginal revenue curve can be seen in the graph below:

As the graph shows, the demand curve is downward sloping, while the total revenue curve is upward sloping but at a decreasing rate. The marginal revenue curve is below the demand curve and intersects the x-axis (i.e. has zero marginal revenue) at a lower quantity than the demand curve. This is because the monopoly has market power and can charge a higher price, but in order to sell more units, it must lower the price, which reduces the marginal revenue.

Profit Maximization for Monopoly Firm

For a monopoly firm, profit maximization occurs where marginal revenue (MR) is equal to marginal cost (MC), just as with perfectly competitive firms. However, because a monopolist has market power, it can choose a price that will maximize profits, rather than simply taking the market price as given.

Here's an example of how a monopoly firm might determine its profit-maximizing level of output and price:

Suppose the monopoly firm has the following demand and cost functions:

Demand: P = 100 - Q

Total cost: TC = 50Q + 100

Where P is the price of the firm's output, Q is the quantity of output, and TC is the total cost of production.

To find the firm's marginal revenue function, we can take the derivative of the demand function with respect to quantity:

MR = 100 - 2Q

To find the firm's marginal cost function, we can take the derivative of the total cost function with respect to quantity:

MC = 50

To find the profit-maximizing level of output, we set MR equal to MC:

100 - 2Q = 50

Q = 25

So the profit-maximizing level of output is 25 units. To find the corresponding price, we substitute this quantity back into the demand function:

P = 100 - Q

P = 100 - 25

P = 75

So the profit-maximizing price is $75 per unit.

To calculate the monopolist's profits, we need to subtract total cost from total revenue. Total revenue is equal to price times quantity:

TR = P x Q

TR = 75 x 25

TR = 1875

Total cost is equal to the sum of fixed cost and variable cost:

TC = 50Q + 100

TC = 50(25) + 100

TC = 1275

So the monopolist's profits are equal to total revenue minus total cost:

π = TR - TC

π = 1875 - 1275

π = 600

The monopolist's profit-maximizing level of output is lower and its price is higher than would be the case in a perfectly competitive market. Additionally, the monopolist earns positive economic profits in the short run, due to its ability to set a price above marginal cost.

Loss Minimization for Monopoly Firm

A monopoly firm may face situations where it incurs losses in the short run. In such cases, the firm has to decide whether to continue operating in the short run or shut down production.

To determine whether the firm should continue producing or shut down, the firm can use the same approach as in the case of a perfectly competitive firm. The firm should compare the total revenue it receives from production with the total variable cost it incurs. If the total revenue is less than the total variable cost, the firm should shut down production, as continuing to produce will result in further losses.

However, in the long run, if the firm is unable to cover its total costs, including fixed costs, it should exit the market. In the long run, the firm has the flexibility to adjust its fixed costs, such as shutting down its plant or reducing its workforce, which is not possible in the short run. Therefore, if the firm is incurring losses in the long run, it should exit the market to minimize its losses.

Here's a tabular example to illustrate loss minimization for a monopoly firm:

Assume that a monopoly firm faces the following cost and revenue functions:

Total cost (TC) = 100 + 10Q

Total revenue (TR) = 20Q

Marginal revenue (MR) = 20

where Q is the quantity of output.

Suppose the market demand is given by:

Market demand (D) = 200 - 2Q

To find the profit-maximizing quantity, we can use the marginal revenue-marginal cost (MR=MC) rule. As mentioned earlier, for a monopoly firm, the marginal revenue is less than the price. Therefore, the profit-maximizing quantity occurs where marginal revenue equals marginal cost.

To find the quantity that maximizes profit, we can start by calculating the marginal cost (MC) of production:

MC = ΔTC/ΔQ = 10

Setting MR equal to MC, we get:

MR = MC

20 = 10

Solving for Q, we get:

Q = 1, which is the profit-maximizing quantity.

To determine whether the firm should shut down production or continue producing, we need to compare the total revenue with the total variable cost (TVC). The TVC is given by:

TVC = 10Q

Substituting the profit-maximizing quantity, we get:

TVC = 10 x 1 = 10

The total revenue is given by:

TR = 20Q = 20 x 1 = 20

Since the total revenue is greater than the total variable cost, the firm should continue producing in the short run, even though it is incurring losses.

However, in the long run, if the firm is unable to cover its total costs, including fixed costs, it should exit the market to minimize its losses. In this example, suppose the fixed cost of the firm is $200. Then the total cost of production is given by:

TC = 200 + 100 + 10Q

Setting TR equal to TC, we get:

20Q = 200 + 100 + 10Q

10Q = 300

Q = 30

The quantity of 30 is the output level that the firm needs to produce to break even in the long run. If the firm is unable to cover its total costs, including fixed costs, it should exit the market to minimize its losses.

Monopoly Firm in the Long Run

In the long run, a monopoly firm can continue to earn economic profits as there are significant barriers to entry that prevent competitors from entering the market and competing for profits.

However, there are some factors that can limit the monopoly firm's long-run profitability, such as the availability of close substitutes, changing consumer preferences, and government regulation.

If there are close substitutes for the monopoly's product, consumers may switch to those substitutes if the monopoly firm raises its prices too high. This can limit the monopoly firm's ability to earn economic profits in the long run.

Similarly, if consumer preferences change and they no longer value the monopoly's product as highly, the monopoly firm may struggle to maintain its market share and profitability.

In addition, government regulation can also limit the monopoly firm's profits. Antitrust laws may prevent the monopoly firm from engaging in certain anti-competitive practices, and regulations may limit the prices the monopoly firm can charge or the profits it can earn.