9.2 How a Profit-Maximizing Monopoly Chooses Output and Price

Monopolies wield significant market power, setting prices and output to maximize profits. Unlike competitive firms, they face downward-sloping demand curves, allowing them to charge higher prices and produce less. This unique position leads to economic inefficiencies and potential consumer exploitation.

The profit-maximizing strategy for monopolies involves equating marginal revenue with marginal cost. This approach, combined with barriers to entry, enables long-term economic profits. However, it also results in allocative and productive inefficiencies, creating deadweight loss for society.

Monopoly Output, Price, and Efficiency

Profit-Maximizing Output and Price

• A monopoly maximizes profit by producing the quantity where marginal revenue (MR) equals marginal cost (MC)
  • MR represents the change in total revenue from selling one additional unit of output
  • MC represents the change in total cost from producing one additional unit of output
• To find the profit-maximizing quantity, a monopoly sets $MR = MC$
• The monopoly then charges the highest price consumers are willing to pay for that quantity, which is determined by the market demand curve
• The monopoly price is higher than the marginal cost at the profit-maximizing quantity, allowing the monopoly to earn economic profits
• Monopolies can earn economic profits in the long run because they face no competition and have barriers to entry (legal, technological, or natural barriers)

Monopoly vs. Perfect Competition

• A monopoly faces a downward-sloping demand curve, while a perfectly competitive firm faces a horizontal demand curve
  • A downward-sloping demand curve means that a monopoly must lower its price to sell more output (price and quantity demanded are inversely related)
  • A horizontal demand curve means that a perfectly competitive firm can sell any quantity at the market price (price taker)
• For a monopoly, the marginal revenue curve lies below the demand curve
  • This is because a monopoly must lower its price on all units sold to sell one more unit, reducing the revenue earned on previously sold units
• For a perfectly competitive firm, the marginal revenue curve is the same as the demand curve (and the price)
  • This is because a perfectly competitive firm can sell any quantity at the market price without affecting the price (no market power)

Economic Inefficiencies

• Monopolies produce less output and charge higher prices compared to perfectly competitive markets, leading to allocative inefficiency
  • Allocative efficiency is achieved when the price equals the marginal cost of production (resources are allocated optimally)
• Monopolies may have less incentive to minimize costs or innovate, leading to productive inefficiency
  • Productive efficiency is achieved when a firm produces at the lowest possible average total cost (no wasted resources)
• Monopolies transfer some of the consumer surplus to the producer in the form of economic profits, resulting in a deadweight loss to society
  • Deadweight loss is the reduction in total surplus (consumer surplus + producer surplus) compared to a perfectly competitive market (represents a net loss to society)
• Monopolies may engage in price discrimination, charging different prices to different consumers based on their willingness to pay
  • Price discrimination can reduce consumer surplus and increase the monopoly's profits (first-degree, second-degree, and third-degree price discrimination)