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๐Ÿ’ธย  Unit 1: Basic Economic Concepts

4.2 Monopolies

#unit4

#monopoly

#profit

#efficiency

#graphs

โฑ๏ธย ย 5 min read

written by

jeanne stansak

Caroline Koffke

caroline koffke

(editor)

November 15, 2020


A monopoly is a market structure in which an individual firm has sufficient control of an industry or market. They determine the terms of access to other firms.

Aย natural monopolyย occurs when an individual firm comes to dominate an industry by producing goods and services at the lowest possible production cost. Since other firms cannot compete with these low costs, it drives them out of the business and allows the dominant firm to monopolize the industry. Natural monopolies are actually beneficial to society because they charge low prices and promote productive efficiency.

Characteristics of Monopolies

  • One, large firm (the firm is the industry)
  • Firms are "price makers"
  • High barriers to entry means firms cannot enter the industry
  • Firms earn long-run profits
  • Products sold are unique
  • Non-price competition is used
  • Firms are inefficient if they are left unregulated

Graphing Monopolies

In a monopoly graph, the demand curve is located above the marginal revenue cost curve. This is because they have to lower their price in order to sell each additional unit. Their profit-maximizing profit output is where MR=MC. The price is determined by going from where MR=MC, up to the demand curve.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-nZHjT1w6BTzY.png?alt=media&token=678c628a-e322-4fa4-83a4-edc2bdc3df0e

The graph above shows a standard monopoly graph with demand greater than MR. It also shows the profit-maximizing output where MR = MC at Q1. You then determine the price by going up from Q1 to the demand curve and labeling the profit-maximizing price at P1.

Profit and Loss on a Monopoly Graph

Many times, when drawing a monopoly graph, we are asked to show either a profit or a loss. We use the cost curve, ATC, to show it. When we are showing a profit, the ATC will be located below the price on the monopoly graph. We shade the area that represents the profit.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-PZlXyCmq5OZq.png?alt=media&token=fe0aa713-a450-49dd-9c17-fc2cfb79c367

Monopoly Graph Showing a Profit

When we are showing a loss, the ATC will be located above the price on the monopoly graph. We shade the area that represents the loss.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-WSfjTOxf02do.png?alt=media&token=86fe9c7d-0627-4469-a5be-673d56b29b2b

Monopoly Graph Showing a Loss

Calculating a Monopoly's Profit

In this particular graph, the firm is earning a total revenue of $1200, which is calculated by multiplying the price they are receiving for each unit by the profit-maximizing output. The total cost is the value of the ATC multiplied by the profit-maximizing output ($2 x 200 = $400). The profit is calculated by subtracting total cost from total revenue ($1200 - $400 = $800).

You can also use the area of a rectangle formula to calculate profit!

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-R77bcz01G9jw.png?alt=media&token=2b2f099c-3661-47cd-8207-51cf5b4dea51

Calculating a Monopoly's Loss

In this particular graph, the firm is earning a total revenue of $500, which is calculated by multiplying the price they are receiving for each unit by the profit-maximizing output. The total cost is the value of the ATC multiplied by the profit-maximizing output ($9 x 100 = $900). The loss is calculated by subtracting total cost from total revenue ($500-$900 = -$400).

You can also use the area of a rectangle formula to calculate loss!

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-zFXlCWvtzXf4.png?alt=media&token=c102485c-5250-44f8-bbae-35a922ce5129

Monopoly and Efficiency

In a perfectly competitive market, firms are both allocatively and productively efficient. One of the ways this is shown is when perfectly competitive firms maximize consumer and producer surplus. Monopolies, on the other hand, are not allocatively and productively efficient because they overcharge and underproduce. Below is a graph that shows consumer and producer surplus on a monopoly graph as well as deadweight loss, the loss of consumer and producer surplus due to inefficiency.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-uSkK6VYT4kiv.png?alt=media&token=0897540f-d8c1-498a-8690-25bd8c6ad080

Key Points on a Monopoly Graph

There are many key points that we should be familiar with on a monopoly graph (please see the graph below to identify all these key points).

  • Profit-maximizing price and outputย (sometimes referred to as loss-minimizing): The output is determined where MR = MC, and then we go up to the demand curve and over to identify the price. (On the graph below it is Q1 and P4.)
  • Socially optimal price and output:ย This is located where P = MC. This is also referred to as the allocatively efficient point on a monopoly graph. This point requires regulation from the government in order to produce here. This is usually done via aย price ceiling,ย which keeps prices low. This forces the monopoly to produce a more allocatively efficient output and eliminate deadweight loss (DWL). (On the graph below it is Q3 and P2.)
  • https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-1onGIg8bfZuS.png?alt=media&token=0dd2bad9-32f0-42b9-bf75-dcd3a26f6e5f
  • Fair-return price and output:ย This is where P = ATC. This should not be confused with the productively efficient point of P = minimum ATC. This is the point on a monopoly graph where total revenue (TR) = total cost (TC), meaning that the monopoly makes a normal profit. This is usually accomplished via a price ceiling. (On the graph below it is Q4 and P1.)

  • Price and output that maximizes total revenue (TR):ย This is located where MR=0. This point is also used to identify the elastic and inelastic parts of the demand curve. (On the graph below it is Q2 and P3.)
  • https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-VwAHoD9ZDdqR.png?alt=media&token=370df098-4fdc-41eb-8a86-07f54285c941

    https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-eGZXaATbWN0k.png?alt=media&token=28f1993e-2740-4ea4-b951-61348a95c2cd

    Monopoly Graph and Elasticity

    The demand curve on a monopoly graph have both elastic, inelastic, and unit elastic sections. We use the quantity where MR=0 to determine the difference. We first draw a line from the quantity where MR=0 up to the demand curve. The point where it hits the demand curve is theย unit elastic point. The section above this point is theย elastic regionย of the demand curve, and the section below this point is theย inelastic regionย of the demand curve.

    In the elastic region, a monopoly can lower the price and still increase their total revenue (TR). However, in the inelastic region, if they lower their price, they decrease their total revenue (remember the Total Revenue Test!). A monopoly will never willingly produce in the inelastic region because it would lower their profits (marginal revenue is negative, while marginal costs continue to increase. In order for them to produce in the inelastic region, the government has to regulate them with a price ceiling or provide support through a subsidy. (See the graph of both a monopoly and a corresponding TR curve below).

    https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-TQbNBwgByrUB.png?alt=media&token=83894f87-5f34-4ff7-886a-b6382ff77d98

    https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-NjDFPz29nqSi.png?alt=media&token=30a58910-8fcf-4d2b-b122-7fc3eeed1e04

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