Chapter 14 (3) Flashcards
We have to begin our analysis of a monopoly’s behaviour by understanding its wants & constraints
► Like any other firm: wants to maximize its profits
It is known that a firm in a perfectly competitive market = constrained by the fact that its production decisions cannot affect the prevailing market price
A monopoly = does not face this constraint–but it is constrained by the market demand curve
MONOPOLISTS AND THE DEMAND CURVE
► As the ONLY PRODUCER in the market –> a monopolist faces the downward-sloping market demand curve
► The monopolist can choose to sell AT ANY PRICE it wants w/out fear of being undercut –> b/c there are no other firms to do the undercutting
○ However, it is still constrained by market demand
Naturally, it would love to sell a huge quantity of goods at a high price
But how would consumers respond to a high-price?
► The monopoly can choose any price-quantity combination on the demand curve –> but is unable to choose points THAT ARE NOT ON THE CURVE
○ It can’t force customers to buy or less than the quantity they demand a any given price
Example: The monopolist can choose to sell at a high price of $5,000 per diamond, but only by selling a small quantity–three diamonds
► Or: it can choose to sell 5 more diamonds –> reaching a total of eight, but only lowering its price to $2, 500 per diamond.
De Beers recognized the fact that its sales were limited by demand
► That’s why it went beyond controlling the supply side of the market & invested heavily in shifting the demand curve outward through the marketing methods
MONOPOLY REVENUE
► The first step in understanding a monopolist’s quest for profits = to map out the revenues it can bring in
Example: can choose the price of the diamonds it offers for sale in Canada
► Let’s assume that De Beers sells diamonds of uniform size (one-carat violet diamonds) and quality
What revenue can it expect to bring in at each possible price?
► Because it is constrained by demand –> DeBeers has to accept the quantity that American consumers are willing to buy at a given price
TOTAL REVENUE - price x quantity
► As price increases & quantity sold decreases – total revenue = first rises & the falls
○ Note, that total revenue increases on sections of the demand curve --> where demand = price-elastic ○ It decreases on sections of the curve where demand = price-inelastic
AVERAGE REVENUE - total revenue / quantity
AR = price
► UNLIKE a firm in a competitive market –> a monopolist’s MARGINAL REVENUE ***is not EQUAL to price
► Marginal revenue = is the revenue generated by selling each additional unit
○ Calculation: by taking total revenue at a certain quantity & subtracting the total revenue when quantity is one unit lower
In a market dominated by a monopoly –> the monopoly’s choice to produce an additional unit drives down the market price
► Because of this effect, producing an additional unit of output has two separate effects on total revenue:
1. QUANITY EFFECT: Total revenue increases due to the money brought in by the sale of an additional unit 2. PRICE EFFECT: Total revenue decreases, because all units sold now bring in a lower price than they did before
Depending on which of these effects = larger, total revenue might increase/decrease when De Beers increases the quantity of diamonds it sells
► Marginal revenue = always less than the price –> except for the very first unit sold
► For that first unit: average revenue & marginal revenue = both equal to the price
Average revenue curve = the same as the market demand curve
► The marginal revenue curve lies below the average revenue curve –> bc marginal revenue = always less than price after the very first unit sold
► Marginal revenue = can sometimes be (-)
► Thus, the point at which the MR curve crosses the x-axis represents the revenue-maximizing quantity
MAXIMIZING PROFITS BY PICKING PRICE & QUANTITY SOLD
► De Beers exerted control over the diamond market through the quantity of diamonds it released for sale at any given time
○ The company = held back stockpiles of diamonds worth billions of dollars for years at a time to maintain this control
Purpose of this stockpiling: was to ensure that the quantity of diamonds for sale = always the quantity that maximized De Beer’s profits
► Sometimes, the profit-maximizing quantity = lower than the total quantity of diamonds available
–> and so it was in De Beer’s interest to hold back from the market
How can a monopolist choose the price-quantity combination that maximizes profit?
► It can approach this problem in exactly the same way that a firm in a competitive market would
► The general appearance of these curves should be familiar from the “Perfect Competition”
► The only relevant difference between the curves for a monopoly & the equivalent ones for a firm in a competitive market:
Is that marginal & average revenue slope downward for the monopolist
PROFIT-MAXIMIZING: MR = MC
► Just as in a competitive market –> the profit-maximizing quantity of output for a monopoly = the point at which the marginal revenue curve intersects the marginal cost curve
Why is it so?
► *Remember - [the difference between marginal revenue and marginal cost] = the contribution of each additional unit of output to a firm’s profit.
► If the marginal revenue of a unit of output > than its marginal cost –> then the unit brings in more money in sales than the firm spends to produce it
○ Thus, it contributes to the firm’s profit
► What if, marginal revenue < than marginal cost?
○ The unit costs more to produce than it brings in –> and the firm loses $$$ by producing it
The same marginal decision-making analysis (Perfect Competition) applies here:
► At any quantity of output BELOW the intersection of the marginal revenue & marginal cost curves –> MR is higher than MC
○ At that point, De Beers could earn more profits by offering an additional diamond for sale
► At any quantity of output ABOVE the intersection –> the company loses profit on each additional diamond offered for sale
○ At that point, De Beers could earn more profits by offering fewer diamonds for sale
Therefore, De Beers should increase the quantity of output up to the point where it can no longer earn more profits by increasing output
► AKA, MR = MC
► It should then stop producing output before it starts losing money
There is an important difference between a firm in a competitive market that produces at the point where MR = C and a monopoly that does the same thing
In a competitive market: MR = Price
For a monopolist: Price > than marginal revenue; therefore, price is also greater than marginal cost at the optimal production point
► The profit-maximizing price = the price on the demand curve that corresponds to the profit-maximizing quantity of output
► This fact, that a monopoly’s profit-maximizing price is > than its marginal costs–is key to understanding how monopolies are able to earn (+) economic profits in the long run
► Monopoly market: other firms can’t enter the market –> due to the barriers to entry that allowed the firm to become a monopolist in the first place
► The result is that a monopolist is able to maintain a price higher than ATC
PROFIT = (P-ATC) X Q
► So if price = greater than ATC –> profits will be (+), even in the long run
