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In the Last Lecture, We Talked About How a Monopolist Maximizes Profits by Choosing the Price and Quantity Where Marginal Revenue Equals Marginal Cost

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In the Last Lecture, We Talked About How a Monopolist Maximizes Profits by Choosing the Price and Quantity Where Marginal Revenue Equals Marginal Cost Other Market Models Monopolies Calculating a Monopolist’s Profit and Loss Page 1 of 1 In the last lecture, we talked about how a monopolist maximizes profits by choosing the price and quantity where marginal revenue equals marginal cost. In this lesson we’ll consider the question, is the monopolist making a profit or not? Because even though you’re doing the best you can you may still not be covering all of your costs. Even though you’re maximizing your profit, you may in effect be simply minimizing your losses. Are you making a positive economic profit or not? In order to answer this question, we need to introduce the average cost curve. Now here’s a curve that we’ve seen before. Remember the average cost curve includes not only the variable costs, but the fixed costs of production as well. The average cost curve is U-shaped and it cuts through the marginal cost curve at the point of minimum average cost. When the marginal cost is below the average cost, it pulls the marginal…well, let me be real clear about this, when the marginal cost curve is below the average cost curve, it pulls the average down. And when the marginal cost is above the average cost curve, it pulls it up. That’s why average cost cuts through marginal cost at the point of minimum average cost. Now this is simply review of our earlier discussion of cost curves. Now we’re ready to ask the question, Is the monopolist making a profit or not? Well, remember what profit is. Profit is defined as equal to total revenue minus total cost. And if we want to divide both the total revenue and the total cost by the quantity we can calculate the profit that the firm is making per unit of output. Now, total revenue is equal to price times quantity. So if we divide price times quantity by the quantity produced, we’re simply going to get the price of the product. And if we divide the total cost by the quantity, we’re going to get the average cost. So the amount of profit that the firm is earning per unit will be the difference between the price and the average cost. We might call this the profit margin or the per-unit profit. If we look at this profit margin and we multiply it by the total quantity of output then we get total profit for the firm. So price minus average cost is the profit per unit and multiplying that by the number of units produced gives us the total profit for the firm. Now let’s find out how much profit our monopolist is making when he maximizes his profits. So remember you maximize profit by producing where marginal revenue equals marginal cost. Drop that down to the horizontal axis, and you get the monopolist’s profit maximizing quantity. Go up to the demand curve, and you get the price the monopolist charges for the product. So here’s the monopolist’s profit-maximizing price, P star sub M. Now how much does it cost the monopolist to produce each one of those units? Well go from the quantity up to the average cost curve and you find the average cost of production. Now I can take this line over to the access and that gives me the average cost of the monopolist when the monopolist is maximizing profit. This rectangle right here- price minus average cost multiplied by the quantity of output- this rectangle is the monopoly profit. Here’s another way of seeing the monopoly profit: price times quantity gives us this big rectangle. Price times quantity is the revenue that the monopolist is earning. Subtract from that revenue the costs of production. So take the average cost, multiply it by the quantity produced, and that gives you the total cost of production. Total revenue minus total cost leaves you with the monopolist’s economic profit, the top rectangle. In this case the average cost is low enough that the monopolist is actually making an economic profit. The economic profit is positive. You can imagine, however, another picture where the average cost curve is further up, that is if we increase the fixed costs of this monopolist, or change the technology or the price of the inputs, or the economies of scale, the average cost curve might be completely above the demand curve. In that case, when the monopolist is maximizing profit, average cost is greater than price, in that case the monopolist would actually be making a loss. However, if average cost is less than price, as in the picture I’ve drawn here, the monopolist is making a positive economic profit. So, monopolies can be profitable, or unprofitable. It all depends on their costs. Let me do a quick review. A monopolist always maximizes profit by pricing the product where marginal revenue equals marginal cost. That’s always the best you can do. However, that doesn’t guarantee that you are making a profit. To find out whether you’re making a profit or not you have to compare the price at that particular output with the average cost of production. If price is greater than average cost of production, the monopolist is making an economic profit. However, if the costs are so high that the average cost is greater than the price at this particular output then the monopolist would be making a loss. So, this is how monopolists try to make a profit and sometimes they’re lucky and wind up with a substantial economic profit. However, is the monopoly good for society or not? If we look at a monopoly from the point of view of normative economics, will we conclude that the monopoly is a good thing or a bad thing. In the next lesson we will look at the social costs of monopoly. .
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