Download Chapter 6: Production and Cost:

How Firms Make Decisions: Profit Maximization?:
The Goal of Profit Maximization:

We will view the firm as a single economic decision maker whose goal is to maximize its
owners’ profit.
Understanding Profit:
 We already know that profit is defined as the firm’s sales revenue minus its costs
of production. But there are two different conceptions of the firm’s costs, and
each of them leads to a different definition of profit.
Two Definitions of Profit:
Definition: Accounting Profit: Total revenue minus accounting costs. Accounting profit
considers only explicit costs, where money is actually paid out *(except for depreciation—
accountants include this as a cost even though no money is paid out).
Accounting profit = Total revenue – Accounting costs
Definition: Economic Profit: Total revenue minus all costs of production, explicit and implicit
(including opportunity costs).
Economic profit = total revenue – All costs of production = Total revenue – (Explicit costs
+ implicit costs).
 The differential between economic profit and accounting profit can mean the difference
between success and failure of a business. While a firm can be earning a substantial
accounting profit, its economic profit could be grossly negative. After all costs are
considered—implicit as well as explicit—total revenue must be sufficient to cover what you
have sacrificed to run the business. For our purposes—understanding the behavior of firms—
economic profit is clearly better. Whether or not a given factory should stay in business,
whether or not it should expand a contract in the long run—it is economic profit that will help
us answer these questions, because it is economic profit that you and other owners care
about.
 The proper measure of profit for understanding and predicting the behavior of firms
is economic profit. Unlike accounting profit, economic profit recognizes all the
opportunity costs of production—both explicit costs and implicit costs.
 Example: Let us consider Microsoft’s “profit” in 2001. “In the year ending in June 2001,
Microsoft had an accounting profit of $5.3 billion. But this was not its economic profit.
Microsoft’s owners—its shareholders—had invested about $47 billion in the company—
money that could have earned interest in a bank or some other financial investment. The
forgone investment earnings must be included as part of the opportunity cost paid by
Microsoft’s owners. Let us suppose that they could have earned 5 percent by putting their
money into some other investment. Then, the forgone investment income was $47 billion
multiplied by 0.05, which equals $2.4 billion. Assuming that the forgone investment income
was the only implicit cost for Microsoft, we then deduct it from the accounting profit of $5.3
billion to obtain an economic profit of $5.3 billion minus $2.4 billion which equals $2.9
billion.”
Why are there profits?
 Profit is a payment for two contributions:
1. Risk taking: the land, labor, and capital that are used to start a business firm are the
responsibility of its owner(s). The individual(s) who took the initiative to set up the
business assume the risk that the business might fail and the initial investment may
be lost. Because the consequences of loss are so severe, the reward for success must
be large in order to induce an entrepreneur to establish a business.
2. Innovation: Profits are also a reward for innovation. When pharmaceutical
companies develop life saving medicines, they earn great profits. Innovation, like
taking on the risk of losing substantial wealth, makes an essential contribution to
production. Profit is, in part, a reward to those who innovate.
The Firm’s Constraints: The Demand Constraint
 Recall: Market demand curves vs. individual demand curves: The market demand curve
tell us the quantity demanded by all consumers from all firms in a market. The individual
demand curve referred to good demanded by one consumer only.
Definition: The Demand curve facing a firm: tells us, for different prices, the quantity of output
that customers will choose to purchase from that firm. Alternatively, the demand curve facing the
firm also shows us the maximum price the firm can charge to sell any given amount of output.
(1) Price
(2) Output
(3) Total
(4) Total cost
(5) Profit
Revenue
>$650
0
0
$300
-$300
$650
1
$650
$700
-$50
$600
2
$1,200
$900
$300
$550
3
$1,650
$1,000
$650
$500
4
$2,000
$1,150
$850
$450
5
$2,250
$1,350
$900
$400
6
$2,400
$1,600
$800
$350
7
$2,450
$1,900
$550
$300
8
$2,400
$2,250
$150
$250
9
$2,250
$2,650
-$400
$200
10
$2,000
$3,100
-$1,000
 This table presents information about Ned’s Beds. Data from the first two columns are
plotted in the figure to show the demand curve facing the firm. At any point along that
demand curve, the product of price and quantity equals total revenue, which is given in
the third column of the table.

The firm can decide either its price or its level of output—but not both. Once it makes
the choice, the other variable is determined by the firm’s demand curve. If the firm
decides upon a particular price that implies a certain level of output, whereas selecting an
output level implies a particular price.
Total Revenue:
 Definition: Total revenue: The total inflow of receipts from selling a given
amount of output. Total revenue is calculated by multiplying the quantity of
output (column 2 in the above table) by the price per unit (column 1 in the table
above).
(1) Price
(2) Output
>$650
$650
$600
$550
$500
$450
$400
$350
$300
$250
$200
0
1
2
3
4
5
6
7
8
9
10
(3) Total
Revenue
0
$650
$1,200
$1,650
$2,000
$2,250
$2,400
$2,450
$2,400
$2,250
$2,000
The Cost Constraint:
Recall:
1. The firm has a production function. The production function illustrates all the different
ways a firm can produce any given level of output. All inputs are variable in the long
run, thus the firm can use any method in its production function. However, in the short
run, the firm is limited by its production function and it is constrained further because
some of its inputs are fixed.
2. The firm must pay prices for each of the inputs that it uses, and we assume that those
prices are determined by the market. The firm can do nothing about those prices.
 The firm uses its production function, and the prices it must pay for its inputs, to determine
the least cost method of producing any given output level. Therefore, for any level of output
the firm might want to produce, it must pay the cost of the “least cost method” of production.
This is the firm’s cost constraint.
(4) Total cost
$300
$700
$900
$1,000
$1,150
$1,350
$1,600
$1,900
$2,250
$2,650
$3,100

Ned’s total cost, illustrated in the table above, is the lowest cost of producing each
quantity of output. More output always means greater costs, so the numbers are always
increasing. Note that we are examining costs in the short run—total cost is $300 at an
output of zero—because some costs are fixed in the short run (such as rent). Also note
that the total costs rises from $300 to $700 when output increases from 0 to 1 bed frame:
a $400 difference—is caused by variable costs such as labor and raw materials.
 The firm faces constraints that limit its ability to earn profit. For each level of output the firm
might choose, its demand curve determines the price it can charge and the total revenue it
will receive. Its production technology and the price of its inputs determine the total cost it
must bear.
The Profit Maximizing Output Level:
The Total Revenue and Total Cost Approach:
So far we know:
1. How much revenue a firm will earn
2. Its cost of production.
 Therefore, to calculate profit we simply take the difference between total revenue
(TR) and total cost (TC).
 In the total revenue and total cost approach, the firm calculates Profit = TR – TC at each
output level and selects the output level where profit is greatest.
(5) Profit
-$300
-$50
$300
$650
$850
$900
$800
$550
$150
-$400
-$1,000

Total profit from Ned’s Beds is listed at each output level. If no beds frames are produced,
total revenue (TR) would be zero, while total cost (TC) would be $300. Therefore the firm
earns negative profit, or a loss of $300 per day ($0 – $300 = $-300).
 Producing one bed frame increases total revenue to $650 and total cost to $700, yet Ned’s
beds still accrues a loss of $50.
 Ned’s Beds finally sees a profit after his firm produces 2 bed frames—his total revenue
($1,200) exceeds his total cost ($900), so his firm sees a profit of $300.
Definition: Loss: A negative profit—when total costs exceeds total revenue.
 Keep in mind that total cost (TC) includes all costs—implicit and explicit—thus the profits
we are calculating are economic profits and losses.
 To find the profit maximizing output level using the total revenue and total cost
approach, we find the profit column with the largest value and the output level at
which it is achieved. In Ned’s Beds case, we choose the highest profit of $900 and
output of 5 bed frames. Therefore the profit maximizing output for Ned’s Beds is 5
bed frames per day.
The Marginal Revenue and Marginal Cost Approach:
Definition: Marginal Revenue (MR): is the change in total revenue from producing one more
unit of output. Mathematically, MR is calculated by dividing the change in total revenue ( TR )
by the change in output ( Q ): MR 
(1) Price
(2)
Output
(3) Total
Revenue
>$650
$650
$600
$550
$500
$450
$400
$350
$300
$250
$200
0
1
2
3
4
5
6
7
8
9
10
0
$650
$1,200
$1,650
$2,000
$2,250
$2,400
$2,450
$2,400
$2,250
$2,000
TR
Q
Marginal (4)
revenue
Total
cost
$300
$650
$700
$550
$900
$450
$1,000
$350
$1,150
$250
$1,350
$150
$1,600
$50
$1,900
-$50
$2,250
-$150
$2,650
-$250
$3,100
Marginal
cost
$400
$200
$100
$150
$200
$250
$300
$350
$400
$450
(5) Profit
-$300
-$50
$300
$650
$850
$900
$800
$550
$150
-$400
-$1,000

Columns for marginal revenue and marginal cost have been added to the TR and TC
columns from the figure above. For simplicity, output is always changing by one unit;
therefore, TR (per unit) will always equal marginal revenue.
Note that:
1. When MR is positive, output increases cause total revenue to rise; however, when MR is
negative, an increase in output causes total revenue to fall.
2. For each bed frame Ned’s Bed’s produces, MR is less than the actual price Ned charges
at the new output level. Further, note how each successive unit sold causes a decrease in
marginal revenue; that is due the firm’s downward sloping demand curve, which tells us
that to sell more output, the firm must cut its price.
 Glance back at the Demand Constraint graph for Ned’s Bed’s—note that when he increased
production from 2 units to 3, his firm was forced to lower the unit price from $600 to $550
for each of the three units his firm produced. While Ned’s firm gained $550 selling the third
bed frame he consequently lost $100 because he had to lower the price by $50 on each of the
two units that otherwise could have been sold at $600. Marginal revenue will always equal
the difference between this gain and loss in revenue—in this case, $550-$100 = $450.
 When a firm faces a downward-sloping demand curve, each increase in output causes a
revenue gain—from selling additional output at the new price—and a revenue loss—from
having to lower the price on all previous units of output. Marginal revenue is therefore less
than the price of the last unit of output.
Using MR and MC to Maximize Profits:
1. An increase in output will always raise profit as long as marginal revenue is greater than
marginal cost (MR>MC).
2. An increase in output will always lower profit whenever marginal revenue is less than
marginal cost (MR<MC).
3. To find the profit maximizing output level, the firm should increase output whenever
MR>MC, and decrease output whenever MR<MC.
The TR and TC Approach Using Graphs: (Using Ned’s Beds Data)


Any output level where TR>TC, where the TR curve lies above the TC curve, Ned’s
Beds is earning a profit.
However, we know that the profit maximizing level for any firm using the total
revenue/total cost approach we find the largest value taking the difference between
total revenue (TR) and total cost (TC).
 To maximize profit, the firm should produce the quantity of output where the vertical
distance between the TR and TC curves is the greatest and the TR curve lies above the
TC curve.
 To maximize profit, the firm should produce the level of output closest to the point where MC
= MR—that is, the level of output at which the MC and MR curves intersect.
The Importance of Marginal Decision Making: A Broader View:
 A firm maximizes profit by taking any action that adds more to its revenue than its cost.

When considering increasing output by 1 unit, we should only do so whenever MR>MC.
Marginal revenue is how much the action of increasing output one unit adds to revenue and
marginal cost is how much increasing output one unit adds to cost.
Dealing with Losses: The Short Run and the Shutdown Rule
 Should a loss-making firm shut down its operation in the short run? Why should a firm
keep producing if it is not making any profit?
 The answer is: it depends.
 In the short run, a firm must continue to pay its total fixed cost (TFC) no matter what level of
output it produces—even if it produces nothing at all. If the firm shuts down, it will therefore
have a loss equal to its TFC, since it will not earn any revenue. But if, by producing some
output, the firm can cut its loss to something less than TFC, then it should stay open and keep
producing.
Definition: The Shutdown Rule: In the short run, the firm should continue to produce if total
revenue exceeds total variable costs; otherwise, it should shut down.
 Let Q* be the output level at which MR = MC. Then, in the short run:
1) If TR>TVC at Q*, the firm should keep producing.
2) If TR<TVC at Q*, the firm should shut down.
3) If TR = TVC at Q*, the firm should be indifferent between shutting down and
producing.
At Q*, this firm’s total variable cost exceeds its total revenue. The best policy is to shut down,
produce nothing, and suffer a loss equal to TFC in the short run.
The Long Run: The Exit Decision:
Definition: Exit: A permanent cessation of production when a firm leaves an industry.
 A firm should exit the industry in the long run when—at its best possible output level—it has
any loss at all.
Perfect Competition:
Definition: Market Structure: The characteristics of a market that influence how trading takes
place.
 By market structure, we mean all the characteristics of a market that influence the
behavior of buyers and sellers when they come together to trade.
 The structure of any particular market can be determined by the answers to the following
three questions:
1. How many buyers and sellers are there in the market?
2. Is each seller offering a standardized product, more or less indistinguishable
from that offered by other sellers, or are there significant differences between the
products of different firms?
3. Are there any barriers to entry or exit, or can outsiders easily enter and leave
this market?
 The four basic types of markets are:
1) Perfect competition
2) Monopoly
3) Monopolistic competition
4) Oligopoly
The focus of this chapter is perfect competition.
What is Perfect Competition?
 In economics, the term “competition” describes a situation of diffuse, impersonal
competition in a highly populated environment.
Definition: Perfect competition: A market structure in which there are many buyers and sellers,
the product is standardized, and sellers can easily enter or exit the market.
The Three Requirements of Perfect Competition:
 Perfect competition is a market structure with three important characteristics:
1. There are large numbers of buyers and sellers, and each buys or sells a
tiny fraction of the total quantity in the market.
2. Sellers offer a standardized, homogenous product.
3. Sellers can easily enter into or exit from the market.

In a perfectly competitive market, each buyer and seller is a price
taker.
A Large Number of Buyers and Sellers:
 In a perfectly competitive market, the number of buyers and sellers is so large that no
individual decision maker can significantly affect the price of the product by changing the
quantity it buys or sells.
Examples: Wheat, cotton, gold, silver, stocks, bonds.
A Standardized Product Offered by Sellers:
 In perfectly competitive markets, buyers do not distinguish considerable differences of the
products of one seller to another. Buyers see the products in perfectly competitive markets
essentially as identical. Example: The manufacturers of Wheaties have no preference of
Bob’s wheat over Andy’s
Easy Entry and Exit from the Market:
 Easy entry into a market does not mean a free entry—the new entrant must incur some
overhead costs, yet a perfectly competitive market has no significant barriers to discourage
new entrants.
 Some markets do have barriers to entry, often imposed by the government; for example, the
number of taxicabs licensed to operate in New York City is fixed by the local government.
Zoning laws are another government imposed barrier to entry.
 Existing sellers’ market dominance can also create barriers to entry without any government
action. Consumer brand loyalty and significant economies of scale often give existing firms a
cost advantage over new entrants.
 Perfect competition also requires easy exit: A firm suffering a long run loss must be able to
sell off its plant and equipment and leave the industry for good, without obstacle. If shutting
down the plant requires intense union litigation, the capital equipment too specialized to be
immediately sold, or if significant barriers to exit arise, then the firm will not conform to the
assumptions of perfect competition.
The Perfectly Competitive Firm:
Goals and Constraints of the Competitive Firm:

A perfectly competitive firm faces a cost constraint like any other firm. The cost of producing
any given level of output depends on the firms’ production technology and the prices it must
pay for its inputs.
The Demand Curve Facing a Perfectly Competitive Firm:
 In perfect competition, the firm is a price taker—it treats the price of its output as given.
Definition: Price taker: Any firm that treats the price of its product as given and beyond its
control.
Cost and Revenue Data for Small Time Gold Mines:
(1) Output (2)Price
(3) Total
(4)
(5) Total
(6)
(7) Profit
(troy
(per troy
revenue
Marginal
cost
Marginal
ounces per
day)
0
ounce)
$400
Revenue
$0
cost
$550
$400
1
$400
$400
$1,000
$400
2
$400
$800
$400
$1,200
4
$400
$1,600
$1,200
$1,250
$2,000
6
$400
$2,400
$100
$1,500
$250
$2,800
$400
$2,100
$3,200
$400
$2,550
$3,600
$400
$650
$550
$3,100
$400
10
$700
$450
$400
9
$650
$350
$400
8
$500
$1,750
$400
$400
$250
$150
$400
7
-$50
$1,350
$400
$400
-$400
$50
$400
5
-$600
$200
$400
3
-$550
$450
$4,000
$500
$650
$3,750
$250
 Because Small Time Gold mines is a perfectly competitive firm—a price taker—its price per
ounce remains constant at $400, no matter how many ounces it produces.
 Marginal revenue remains constant at $400. Why? Price remains constant at
$400 and each time the firm produces another ounce of gold, total revenue
increases by $400.

For a competitive firm, marginal revenue at each quantity is the same as the market
price. For this reason, the marginal revenue curve and the demand curve facing the firm
are the same—a horizontal line at the market price.
 It is especially important to notice that in panel (b) the horizontal line is labeled “d = MR”—
since this line is both the firm’s demand curve (d) and its marginal revenue curve (MR).
Finding the Profit Maximizing Output Level: (recall chapter 7)
 Competitive firms, like all firms, want to maximize profits, and to do so it will
use the principles demonstrated in chapter 7 (the TR/TC approach and the
MR/MC approach)

Ned’s Beds, the firm we examined in chapter 7 did not operate under perfect
competition. As a result, both its demand curve and its marginal revenue curve sloped
downward. Small Time, however, operates under perfect competition, so its demand and
MR curves are the same horizontal line.
Measuring Total Profit:
 We already know that the vertical distance between the TR and TC curves gives
us a firm’s profit. Now we will learn another way to measure profit:
 Profit per unit = P - ATC
 A firm earns a profit whenever P>ATC. Its total profit at the best output level
equals the area of a rectangle with height equal to the distance between P and
ATC, and width equal to the level of output.
 A firm suffers a loss whenever P<ATC at the best level of output. Its total loss
equals the area of a rectangle with height equal to the distance between P and
ATC, and width equal to the level of output.
The Firm’s Short-Run Supply Curve:
 How does a competitive firm maximize profit when market price changes in the short
Short-Run Supply Curve
(a)
(b)
Dollars
Price
per Bushel
Firm’s
Supply
Curve
MC
$3.50
2.50
2.00
d 1 = MR 1
ATC
d 2 = MR 2
AVC
d 3 = MR 3
1.00
0.50
d 4 = MR 4
d 5 = MR 5
1.00
0.50
$3.50
1,000
2,000
4,000
5,000
7,000 Bushels
per Year
2.50
2.00
2,000
4,000
5,000
7,000 Bushels
per Year
run?
 Panel (a) shows a typical competitive firm facing various market prices. For prices between
$1 and $3.50 per bushel, the profit maximizing quantity is found by sliding along the MC
curve. Below $1 per bushel, the firm is better off shutting down, because P<AVC, so
TR<TVC. Panel (b) shows that the firms supply curve consists of two segments. Above the
shutdown price of $1 per bushel it follows the MC curve; below that price it is synchronized
with the vertical axis.
 The figure above shows ATC, AVC, and MC curves for a competitive producer of
wheat. Note that there are five different demand curves that the firm could face.
 As the price of output changes, the firm will slide along its MC curve in deciding how
much to produce.
Recall:
1. AVC * Q = TVC
2. A firm should never shut down when TR>TVC
3. A firm should always shut down when TR<TVC
Definition: Shutdown Price: The price at which a firm is indifferent between producing and
shutting down. [The firm will] shut down at a price any lower and stay open at any price higher.
 For all prices above the minimum point on the AVC curve, the firm will stay open and will
produce the level of output at which MR = MC. For these prices, the firm slides along its
MC curve in deciding how much output to produce. But for any price below the minimum
AVC, the firm will shut down and produce zero units.
Definition: Firm’s supply curve: A curve that shows the quantity of output a competitive firm
will produce at different prices.


The competitive firm’s supply curve has two parts. For all the prices above the
minimum point on its AVC curve, the supply curve coincides with the MC curve.
For all prices below the minimum point on the AVC curve, the firm will shut
down, so its supply curve is a vertical segment at zero units of output (see graph
above).
 In the short run, the number of firms in the industry is fixed.
The Short-Run Market Supply Curve:
Definition: Market Supply Curve: A curve indicating the quantity of output that all sellers in a
market will produce at different prices. To obtain the market supply curve, we add up all the
quantities of output supplied by all firms in the market at each price.

In perfect competition, the market sums up the buying and selling preferences of individual
consumers and producers, and determines the market price. Each buyer and seller then takes
the market price as given, and each is able to buy or sell the desired quantity.
Competitive Markets in the Long Run:

In the short run, we know that the number of firms in a perfectly competitive is fixed;
however, in the long run entry and exit can occur.
Profit and Loss and the Long Run:
 In a competitive market, economic profit and loss are the forces driving long run
change. The expectation of continued economic profit causes outsiders to enter
the market; the expectation of continued economic losses causes firms in the
market to exit.
Long-Run Equilibrium: From Short-Run Profit to Long-Run Equilibrium:

Assume the market for wheat is in short-run equilibrium at $4.50 per bushel and the
equilibrium price lays above the ATC curve per bushel for a given firm. With P>ATC
the firm will earn an economic profit in the short run.

Attracted to economic profit, new firms enter the market and increase overall
market production effectively causing the market supply curve to shift rightward:
1. The market price will fall.
2. As the market price falls, the marginal revenue and demand curve for
the firm shift further downward.
3. Attempting to maximize profit, the firm will decrease output and
slide down its marginal cost curve.
 New entrants will continue to shift the market supply rightward until the
market supply shifts so far rightward such that each existing firm is earning
zero economic profit.

In a competitive market, positive economic profit continues to attract new entrants until
economic profit is reduced to zero.
From Short Run Loss to Long-Run Equilibrium:

In a competitive market, economic losses continue to cause exit unit the losses
are reduced to zero.
The Notion of Zero Profit in Perfect Competition:
Definition: Normal Profit: Another name for zero economic profit
 In the long run, every competitive firm will earn normal profit—that is, zero
economic profit.
Perfect Competition and Plant Size:
 In the long-run equilibrium, every competitive firm will select its plant size and
output level so that it operates at the minimum point of its LRATC curve.
Summary: The Perfectly Competitive Firm in the Long Run

At each competitive firm in the long run, P = MC = Minimum ATC = minimum
LRATC.
Producing goods at the minimum average cost means that firms are producing at the lowest
possible cost per unit, which results in economic efficiency.
 The long run supply curve shows the relationship between market price and
market quantity produced after all long-run adjustments have taken place.

An increasing cost industry in which the long-run supply curve slopes upward
because each firm’s ATC curve shifts upward as industry output increases.

A constant cost industry is an industry in which the long-run supply curve is
horizontal because each firm’s ATC curve is unaffected by changes in industry
output.

A decreasing cost industry is an industry in which the long run supply curve
slopes downward because each firm’s ATC curve shifts downward as industry
output increases.
 In a market economy, price changes act as market signals, ensuring that
the pattern of production matches the pattern of consumer demands.
When demand increases, a rise in price signals firms to enter the market,
increasing industry output. When demand decreases, a fall in price
signals firms to exit the market, decreasing industry output.
Monopoly
A monopoly market is distinguished by:
1. Only one seller
2. No close substitutes
3. Barriers to entry
Definition: Monopoly firm: The only seller of a good or service that has no close substitutes.
Definition: Monopoly market: The market in which a monopoly firm operates.
The Sources of Monopoly:
1. Economies of Scale: As we know from chapter 6, a firm’s long run average cost curve
slopes downward due to economies of scale. If these economies of scale continue until a
single firm is the only producer in the market, we call this a natural monopoly.
Definition: Natural monopoly: A market in which, due to economies of scale, one firm can
operate at lower average cost than can two or more firms.

If every firm in the market initially had the LRATC curve ATCo; suppose one firm
grows larger, it can produce at a lower cost per unit than the smaller firms, as illustrated
in curve ATC’ above. This allows firm ATC’ to charge a lower price than the firm
producing at ATCo, thus the smaller firm will experience economic loss and will be
inclined to leave the market or merge with the larger firm. As the larger firm expands,
their average costs per unit continue to drop. Eventually, due to economies of scale, there
remains only one firm in the market.
2. Control of Scarce Inputs: De Beers of South Africa is one the world’s strongest
monopolies. They produce approximately 50 percent of the world’s rough cut diamonds
and resells diamonds. De Beers only sells a limited quantity of diamonds to maintain an
“appropriate” price.
3. Government-enforced barriers:
a) Protection of Intellectual property:

In dealing with intellectual property, government strikes a
compromise: it allows the creators of intellectual property to enjoy a
monopoly and earn economic profit, but only for a limited period of
time. Once the time is up, other sellers are allowed to enter the
market, and it is hoped that competition among them will bring down
prices.
Definition: Patent: A temporary grant of monopoly rights over a new product or scientific
discovery.
Definition: Copyright: A grant of exclusive rights to sell a literary, musical, or artistic work.
b) Government franchise: a government-granted right to be the sole seller of a
product or service.
 Example: The US Postal Service.
Monopoly Goals and Constraints:


A monopolist tries to maximize profits like every other firm, but it faces constraints as
well; it must pay for its inputs; which, in combination with its production technology
determine its output.
The monopoly’s demand curve is the market demand curve because it is the only firm in
the market.
For any level of output a monopoly firm produces, total cost is determined by:
1. The firm’s production technology
2. The price of its inputs
 The demand curve facing a monopoly firm is downward sloping; the firm must lower its
price to sell more output. Marginal revenue (MR) is the change in total revenue that
results from increasing output one unit.
Monopoly Price or Output Decision:
 The monopoly can either decide the price or output level but not both. If the firm determines
an output level, then it also determines the maximum price it can charge at that output level.
o Marginal revenue is less than price
o If the monopoly decides to produce more units, it must lower the price on that
and all previous units
 Whenever a firm faces a downward sloping demand curve, marginal
revenue is less than the price of the output; thus, the marginal revenue
curve will lie below the demand curve.
 A monopoly will never produce a level of output at which its marginal revenue is
negative.
 To maximize profit, the firm should produce the level of output where MC = MR
and the MC curve crosses the MR curve from below.
Profit and Loss:
Recall: Profit per unit = P – ATC



We already know that any firm maximizes profit by producing where MR = MC, as long
as P>AVC.
In this figure MR = MC at output level Qo, therefore this firm will charge a price of Po,
the price determined for this level of output on the firm’s demand curve.
The price point Po is greater than average total cost [ATCo] thus the firm earns an
economic profit.
 A monopoly suffers a loss whenever P<ATC. Its total loss at the best output level
equals the area of a rectangle with height equal to the distance between ATC and
P and width equal to the level of output.
Equilibrium in Monopoly Markets:
Short-Run Equilibrium:
 Any firm—including a monopoly—should shut down if P<ATC at the output level
where MR = MC. This possibility is illustrated below:
In this diagram, the firm receives economic losses equal to the shaded area. Since price is above
AVC, though, it will continue operations in the short run, but will leave the industry in the long
run.
Long-Run Equilibrium:
 Unlike perfectly competitive firms, monopolies may earn economic profit in the long run
due to barriers of entry into the market.
 A privately owned monopoly suffering an economic loss in the long run will exit the
industry, just as would any other business firm. In the long run, therefore, we should not
find privately owned monopolies suffering economic losses.
Comparing Monopoly to Perfect Competition:
 Perfect competition eventually leads firms to earn zero economic profit; however,
monopoly markets will have a higher price and lower output than an otherwise similar
perfectly competitive market.
 Assume a hypothetical monopoly consists of the 100 previously competitive firms, as
discussed above, and the market demand curve is the now the monopoly’s demand curve.
We know that the monopoly faces a downward sloping market demand curve and its
marginal revenue will be less than price. The monopoly, attempting to maximize profits, will
then find the output level where MC = MR. The monopoly’s marginal cost curve will be the
same as the market supply curve (as in panel (a) above).
 The monopolization of a competitive industry leads to two opposing effects. First, for
any given technology of production, monopolization leads to higher prices and lower
output. Second, changes in the technology of production made possible under
monopoly may lead to lower prices and higher output. The ultimate effect on price
and quantity depends on the relative strength of these two effects.
Why Monopolies Often Earn Zero Economic Profit:
1. Government regulation: Often, (in cases of natural monopolies), a firm is permitted by
the government to be the sole seller in a market. We see this today in the water,
electrical, and natural gas markets. However, in exchange, the monopoly accepts a
degree of government regulation; often the firm is forced to submit prospective prices to
a public commission for approval. The government, however, is not trying to maximize
the firm’s profit and merely is trying to keep the firm in business.
2. Rent seeking activity: Definition: Any costly action a firm undertakes to establish or
maintain its monopoly status.
 Rent seeking activities (bribes, opportunity costs of time lost lobbying legislators and
the public for “favorable” policies) which are intended to establish or maintain a
firm’s monopoly position, are part of a firm’s costs. As a result, rent-seeking activity
tends to reduce the economic profit of the firm and may even reduce it to zero.
Price Discrimination:
Definition: Single-price monopoly: A monopoly firm that is limited to charging the same price
for each unit of output sold.
Definition: Price discrimination: Charging different prices to different customers for reasons
other than differences in cost.
Requirements for Price Discrimination:
1. There must be a downward sloping demand curve for the firm’s output. In other words,
the firm cannot be in a perfectly competitive market (wheat, gold, corn, silver, etc…).
2. The firm must be able to identify customers willing to pay more. The firm must be able to
sort customers based on their elasticity of demand.
3. The firm must be able to prevent low-price customers from reselling to high price
customers. Resale of the product or service should not be possible.
Effects of Price Discrimination:
1. Price discrimination that harms consumers:
 When price discrimination raises the price for some consumers above the price they
would pay under a single-price policy, it harms consumers. The additional profit for
the firm is equal to the monetary loss of consumers.
2. Price discrimination the benefits consumers:
 When price discrimination lowers the price for some consumers below what they
would pay under a single-price policy, it benefits consumers as well as the firm.
Perfect Price Discrimination:
Definition: Perfect price discrimination: Charging each customer the most he or she would be
able to pay for each unit purchased.
 For a perfect price discriminator, marginal revenue is equal to the price of the additional
unit sold. Thus, the firm’s MR curve is the same as its demand curve.
 A perfect price discriminator increases profit at the expense of consumers, charging each
customer the most he would willingly pay for the product.