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- - : Maximum-profit equilibrum: monopoly

: Maximum-profit equilibrum: monopoly

MAXIMUM-PROFIT EQUILIBRIUM: MONOPOLY

1. If an industry is to be classed as one of pure (or perfect)

competition, there are said to be two basic requirements.It is argued that when

these two conditions are satisfied, the result is, for the individual firm, a

demand curve that is virtually horizontali.e., perfectly or almost perfectly

elastic with respect to price. The firm is free to sell as much or as little as

it pleases at a market price over which it has no control.

Very few real-life firms find themselves in this position. This is because (so

the present chapter argues) of failure to satisfy one or both of the two basic

requirements for perfect competition. In real life, that is, the number of

firms may be too (large/small) for perfect competition. In addition,

the products sold by the various firms may be (identical among all

firms/differentiated from one firm to the next).

(i) many small firms, (ii) all selling identical pro-ducts:

small: differentiated from one firm to the next.

2. These two characteristicsa too-small number of sellers and/or the

differentiation of the competing productsare said to have "monopolistic"

consequences.

Notice that this word "monopolistic" does not mean that the firms

involved are monopolies. The conventional definition of a monopoly situation

is this: (i) only one firm in the industry, and (ii) no close substitutes

available for the product of that one-firm industry.

Except in a few special areas such as public utilities, cases approximating

genuine monopoly are almost as difficult to find as are cases of perfect

competition. Monopoly is a kind of extreme instance of competitive

imperfection. Economist Edward H. Chamberlin, who did much to develop the

ideas set out in the first part of this chapter, argued that the typical

real-life situation is one of "monopolistic

competition." Each firm finds that it must reckon with the competition of

close substitute products (so that it is not a monopoly); and yet its

situation is not that of pure or perfect competition.

The word "monopolistic" is used because it is argued that there is one

monopoly-like characteristic to be found in all such cases of monopolistic or

imperfect competition.

less than perfectly elastic with respect to pricei.e., it is "tilted" rather

than horizontal.

3. If the number of selling firms is small, the name given to the

resulting situation is

If the number of selling firms is large, but competition is not perfect, this

must be (in the language of the text) a situation of

oligopoly: many differentiated sellers.

In its opening sections, this text chapter describes the circumstances of

imperfect or monopolistic competition. But it does not attempt to explore

these situations in any real detail. Instead, after its introductory outline,

the chapter turns to an examination of the profit-maximizing behavior of a

monopoly firm. Analytically, this monopoly case is decidedly easier than the

so-called "intermediate" casesthose not perfectly competitive, and yet not

completely monopolistic. It would be unwise to tackle these more intricate

cases before having mastered the elementary ideas of monopoly pricing.

Even the terms and diagrams involved in a description of monopoly pricing

may seem complicated at first. Yet the basic idea involved is simple. The

monopoly firm is assumed to behave so as to "maximize its profit"which is

exactly what the firm in pure (or perfect) competition was assumed .The

monopoly firm simply operates in rather different circumstances.

To review the basic ideas of "profit maximization":

1. "Maximizing profit" means making as much money as supply conditions

will permit.

2. To "maximize profit," there must be something the firm can do

that will influence its profit. There must be some variable which changes

profit, and which the firm can control.

3. This chapter assumes that the monopoly firm can control the quantity

it sells, just as the firm in pure (or perfect) competition can do. (In real

life, this control is at best indirect and incomplete; there are other and

more complex decisions to be made. But this chapter tackles a simple case.) So

the variable which the monopoly firm can control is its sales quantity: it

looks for the particular sales quantity that will maximize its profit.

4. The monopoly firm is assumed to have control over its sales quantity

because it knows the demand schedule for its producti.e., it knows the sales

quantity that goes with each and any price it might charge.

5. From this demand schedule, it is easy to develop a revenue

schedule (Total Revenue being quantity sold multiplied by price per unit)i.e.,

a schedule showing revenue associated with each possible quantity sold.

6. The firm must know also the Total Cost of each and any output

quantity. By bringing together the revenue and cost schedules, it can then

identify that output quantity at which the excess of revenue over cost (profit)

is greatest. (And it can tell the price to charge for this Maximum-profit

output just by consulting the demand schedule once again.)

To repeat, the essential thing to grasp about this sequence of ideas is that

it is simple. It is only when the monopoly firm's profit-maximizing

"equilibrium position" (with respect to sales output and price) is outlined in

marginal terms that it may seem complicated. But these marginal terms are

essential analytic tools when one moves on to more complex situations. Hence

the emphasis on Marginal Revenue and Marginal Cost in the text chapter and in

the review questions which follow.

4. Columns (1) and (2) of Study Guide Table 1 represent a demand

schedule. This schedule has been computed or estimated by a firm as indicating

the quantities it can sell daily at various prices.

Table 1

This firm must operate under conditions of (perfect/imperfect)

competition, since as the output to be sold increases, price (remains

constant/must be reduced).

5. We treat the first two columns of Table 1 as representing a monopoly

firm's demand schedule. Our task is to determine what price the

monopolist will charge, and what output it will produce and sellif its

objective is Maximum-profit.

o. Column (3) of Table 1 shows Total Revenueprice times quantity. Complete

the four blanks in this column.

Then use Columns (2) and (3) figures to illustrate Total Revenue on Study Guide

Fig. 1i.e., show Total Revenue associated with various output quantities. Join

the points with a smooth curve. Disregard momentarily the TC curve

already drawn on Fig. 1.

. Notice that this demand schedule becomes price-inelastic , when price is

sufficiently loweredspecifically, when price reaches $(8/7/6/5/4).

The graph of Columns (1) and (2) of Table 2 is already drawn on Fig.1 as a Total

Cost curve (TC). (Mark the curve you drew in question 5 as TR, to

distinguish it from the cost curve.)

It is now possible to see at once why the profit-maximizing process outlined

here is a simple one. The firm is doing nothing more than to search for the

output at which the vertical distance between TR and TC is

greatest. This distance, for any output, is (fixed cost/price/profit or

loss). (If TR is above TC, it is profit; if TC is above, it is

loss.' So it is preferable to look for "greatest vertical distance" with

above TC. The greatest distance with on top marks the maximum-possible

loss, which is somewhat less desirable as an operating position.)

6. Figure 1 is too small to indicate quickly the precise Maximum-profit

position. But even a glance is sufficient to indicate that this best-possible

position is approximately i.45/65/85) units of output.

The firm can be thought of as gradually increasing its output and sales,

pausing at each increase to see if its profit position is improved. Each extra

unit of output brings in

a little more revenue (provided demand has not vet moved to the price-inelastic

range); and each extra unit incurs a little more cost. The firm's profit

position is improved if this small amount of extra revenue (exceeds/is

equal to/is less than) the small amount of extra cost.

More elegantly put, output should be increased, for it will yield an increase in

profit, if Marginal Revenue (MR) (exceeds/is equal to/is less than)

Marginal Cost (MC). The firm should cut back its output and sales if it

finds that MR (exceeds/is equal to/is less than) MC.

And so the "in-balance" position is where MR is (less than/equal

to/greater than) MC.

7. A more careful development of the Marginal Revenue idea is needed.

Column (4) in Table 1 shows the extra number of units sold if price is reduced.

Column (5) shows extra revenue (positive or negative) accruing from that price

reduction. Complete the blanks in these two columns to familiarize yourself

with the meanings involved.

8. The general profit-maximizing rule is: Expand your output until you

reach the output level at which MR = MCand stop at that point.

The profit-maximizing rule for the firm in pure (or perfect) competition: P =

MC. This is nothing but a particular instance of the MR = MC rule.

It is assumed in pure (or perfect) competition that the demand curve facing

the individual firm is perfectly horizontal, or perfectly price-

(elastic/inelastic}. That is, if market price is $2, the firm receives

(less than $2 /exactly $2/more than $2) for each extra unit that it sells.

In this special case, MR (extra revenue per unit) is (greater than/the same

thing as/less than) price per unit (which could be called Average Revenue,

or revenue per unit). So in pure (or perfect) competition, P == MC and

MR = MC are two ways of saying the same thing.

9. In imperfect competition, the firm's demand curve isand things

are different. From inspection of the figures in Table 1 [compare Columns (1)

and (6)], it is evident that with such a demand curve, MR at any particular

output is (greater than/the same thing as/less than) price for that

output.

Why is this so? Suppose, at price $7, you can sell 4 units; at price $6, 5

units. Revenues associated with these two prices are respectively $28 and $30.

Marginal Revenue from selling the fifth unit is accordingly $(2/5/6/7/28/30).

It is the difference in revenue obtained as a result of selling the one extra

unit. Why only $2when the price at which that fifth unit sold was 86? Because

to sell that fifth unit, price had to be reduced. And that lowered price

applies to all 5 units. The first 4, which formerly sold at $7, now

bring only $6. On this account, revenue takes a beating of $4. You must

subtract tins $4 from the $6 which the fifth unit brings in. This leaves a net

gain in revenue of $2Marginal Revenue.

10. To return to the fortunes of the firm in Tables 1 and 2: The

tables do not provide sufficient unit-by-unit detail to show the exact

Maximum-profit output level. But Table 1 indicates that between sales outputs

of 63 and 71, MR is $1.63. The MR figures fall as sales are

expanded, so that the $1.63 would apply near the midpoint of this range, say at

output 67. It would be somewhat higher between 63 and 66; somewhat lower

between 68 and 71.

Similarly, MC (Table 2) would be SI.60 at output of about 67 units. So

the Maximum-profit position would fall very close to 67 units produced and sold

per period.

To sell this output, the firm would charge a price (see Table 1) of about 8(7

'5.75/4/1.60). Its Total Revenue [look for nearby figures in Column (3)]

would be roughly $(380/580/780). Its Total Cost (Table 2) would be

roughly ^(310/510/710), leaving profit per period of about $70.

$5.75; $380; $310.

11. The text notes that in geometric terms Marginal Revenue can be depicted as

the slope of the Total Revenue curve.

12. Tills can be illustrated by looking more carefully at the Total Revenue

curve you have drawn in Study Guide Fig. 1. Study Guide Fig. 2 shows an

enlargement of a small segment of that curve: that part of the curve between

output quantities of 25 and 31. If 25 units are sold, the price is 810 and

Total Revenue is $250. This is point A on Fig. 2. If price is reduced

to $9, that increases sales by 6 units, from 25 units to 31 units. Thus Total

Revenue becomes $279 (31 multiplied by $9). So, if the firm reduces price from

$10 to $9, in effect it moves from point A to point B.

Figure 2's heavier, curved line is the smooth curve used to join points A and

B. It is an approximation of the points that would be obtained if we had

quantity and revenue information on prices such as '59.90, S9.SO, and so on.

There is also a straight line (the thin line) joining A and B. It is

close to the probable true Total Revenue curve although it is not likely to be

the exact curve.

Instead of dropping from price $10 all the way to $9, suppose we had moved

only to (say) $9.60. That would have produced (roughly) a 2-unit increase in

quantity demanded. In this way, we would move closer to the true MR figure

than our previous 6-unit approximation supplied. In Fig. 2 terms, we would be

moving from A only to

D, not from A to B. Notice carefully that the straight line (the thin line)

joining A to D becomes a (better/poorer) approximation of the presumed

true Total Revenue curve than was the case when the points involved were A and

B.

In sum, the closer we move point B to point A (for example, if we make it D

rather than B), the closer the slope figure comes to being a measure of the

true MR figure. Strictly speaking, we have true MR (the rate of change

in revenue as measured in terms of 1-unit output changes) only when the line

whose slope is being measured and used to indicate MR is actually

tangent to the Total Revenue curve.

In its near-closing section Bygones and Margins, the text chapter emphasizes

that if a firm is setting its price and output according to MR = MC

principles, it will disregard Fixed Cost.

QUIZ: Multiple Choice

1. If a firm's Marginal Revenue exceeds its Marginal Cost,

Maximum-profit rules require that firm to (1) increase its output in both

perfect and imperfect competition; (2) increase its output in perfect but not

necessarily in imperfect competition; (3) increase its output in imperfect but

not necessarily in perfect competition; (4) decrease its output in both perfect

and imperfect competition; (5) increase price, not output, in both perfect and

imperfect competition.

2. Whenever a firm's demand curve is horizontal or "perfectly

elastic," then (1) the firm cannot be operating under conditions of perfect

competition; (2) the profit-maximizing rule of MR-equal-to-MC does not apply;

(3) price and Marginal Revenue-must be one and the same; (4) price and Marginal

Cost must be one and the same; (5) none of the above is necessarily correct.

3. A basic difference between the firm in perfect (or pure)

competition and the monopoly firm, according to economic analysis, is this:

(1) The perfect competitor can sell as much as he wishes at some given price,

whereas the monopolist must lower his price whenever he wishes to increase the

amount of his sales by any significant amount;

(2) the monopolist can always charge a price that brings him a substantial

profit, whereas the perfect competitor can never earn such a profit; (3) the

elasticity of demand facing the monopolist is a higher figure than the

elasticity of demand facing the perfect competitor; (4) the monopolist seeks

to maximize profit, whereas the perfect competitor's rule is to equate price

and Average Cost; (5) none of the above.

4. "Oligopoly" means (1) the same thing as imperfect competition;

(2) a situation in which the number of competing firms is large but the

products differ slightly; (3) a situation in which the number of competing

firms is small;

(4) that particular condition of imperfect competition which is just removed

from monopoly, regardless of the number of firms or type of product: (5) none

of these.

5. When a monopoly firm seeking to maximize its profits has reached

its "equilibrium position," then (1) price must be less than Marginal Cost;

(2) price must be equal to Marginal Cost; (3) price must he greater than

Marginal Cost; (4) price may be equal to or below Marginal Cost, but not above

it; (5) none of the above is necessarily correct since equilibrium does not

require any particular relation between price and Marginal Cost.

6. To explain why imperfect competition is far more prevalent than

perfect competition, the text lays considerable emphasis upon the following:

(1) the fact that Marginal Revenue is less than price; (2) the tendency of

Marginal Cost to continue to fall over substantial levels of output produced;

(() the disposition of firms to try to maximize the profit they can gain from

sales; (4) the tendency of Marginal Cost to rise after some particular level of

output produced has been reached; (5) the fact that large firms now typically

produce many different products, thus squeezing smaller firms out of their

markets.

7. Among the five statements below, one must be false with

respect to any firm operating under conditions of imperfect competition. Which

one? (1) The number of competing sellers offering similar (although

differentiated) products can be large. (2) Other firms may sell products

which are identical or almost identical with this firm's product. (3) The

number of competing sellers offering similar (although differentiated)

products can be small. (4) The firm's Marginal Revenue will be less than the

price it obtains. (5) The demand curve facing the firm can be perfectly

horizontal.

8. A level of output for a firm at which Marginal Cost had risen to

equality with price would (1) be a profit-maximizing output level in both

pure (or perfect) competition and imperfect competition; (2) be a

profit-maximizing output level in pure (or perfect) competition but not in

imperfect competition; (3) not be a profit-maximizing output level either in

perfect or in imperfect competition; (4) be a profit-maximizing output level in

imperfect competition but not in pure (or perfect) competition; (5) definitely

be a profit-maximizing output level in imperfect competition, but might or

might not be in pure (or perfect) competition.

9. A firm in conditions of imperfect competition which finds itself

at an output level where Marginal Cost has risen to equality with price, and

which wants to maximize its profit, ought to (1) increase its output; (2)

change (either increase or decrease) its price but not its output; (3) maintain

both price and output at their present levels; (4) increase its price; (5)

perhaps do any of the aboveinformation furnished is insufficient to tell.

10. The essence of the general rule for maximizing profits given in

the text chapter is that a firm should set its price, or its output, as

follows: set its (1) price at a level where the excess over the

minimum-possible level of Average Cost is at its maximum; (2) output at a level

where the extra production cost resulting from the last unit produced just

equals the extra revenue brought in by that last unit; (3) price at the highest

level which the traffic will bear; (4) price at a level just equal to Marginal

Cost (assuming that Marginal Cost would rise with any increase in output); (5)

output at a level where Average Cost is at a minimum.

11. A firm would be designated as a monopoly, according to the

definition conventionally used by economists, in any situation where (1)

the firm's Marginal Revenue exceeds the price it charges at all levels of

output (other than the first unit sold); (2) the firm's Marginal Revenue is

less than the price it charges at all levels of output (other than the first

unit sold); (3) the firm has at least some degree of control over the price

that it can charge; (4) the profit earned by the .firm significantly exceeds

the competitive rate of return, after proper allowance has been made for risk

undertaken; (5) there is no other firm selling a close substitute for the

product of this firm.

12. The Marginal Revenue (MR) associated with any given point on a

firm's demand curve will be related to the elasticity of demand at that point

(with respect to price) as follows:

(1) When demand is inelastic, MR will be negative in value;

(2) when demand is elastic, MR will be negative in value;

(3) when demand is inelastic, MR will be zero in value; (4)

when demand is elastic, MR will be zero in value; (5) .VR of monopoly

or imperfect competition. The AR line is Aver-is always positive in value

(although below price) regardless age Revenuein other words, it is

price obtainable per unit. of elasticity, except at the point or region of

unit elasticity.

© , 2012