11.a.

Profit-Maximization by a Monopolist

A monopoly is a firm that is the exclusive seller of a product with which there are no close substitutes. The
monopoly retains this control because it is not possible for other firms to enter into that particular market;
therefore, eliminating competition over the selling of that product. This concept is known as barriers to entry.

The fundamental difference between a competitive firm and a monopolistic firm is the monopolys influence
over the price of its product or output. This arises because a competitive firm is too small in relation to its
market in which it operates to have any control over the price of its output. However, a monopoly does not face
this dilemma because it is the only producer in its market so it adjusts the price of its output by simply changing
the quantity it supplies. This illustrates the characteristic of a monopolistic firm as a price maker. Since
monopolies are the only producer in its market and are price makers they face a downward sloping market
demand curve and thus must sell at a lower price in order to sell more output.

Like a competitive firm, a monopoly operates at maximum profit where its marginal revenue equals its
marginal cost. However, its marginal revenue curve is no longer equal to its demand curve because the
downward sloping quality of its demand curve causes the monopoly to lower its prices in order to increase the
quantity, resulting in less revenue per extra unit of output. Therefore, in order to find the price a monopoly
charges you must determine the profit-maximizing quantity where its marginal revenue equals its marginal cost
and then go up to its demand curve at that quantity.

Below are two examples that provide first a conceptual understanding then second a numerical explanation of a
monopolys profit-maximization.

Example #1:
Imagine there is some sort of monopoly over a product of software, like Microsoft. In columns 1 and 2 of Table
11.a.1 we can see the demand schedule for this particular monopoly. From this you can see that as the quantity
increases the price decreases, representing the downward sloping demand curve characteristic of monopolies.
The third column computes the firms total revenue which calculates the quantity sold (column 1) times the
price (column 2). By looking solely at this column we would conclude this firm should produce at a quantity of
3 or 4. However, we can take it one step further by computing the firms profit by subtracting the firms total
cost (column 4) from its total revenue (column 3) at each quantity. This column indicates that at 4 units the firm
will experience a loss in profit even though it appeared the firm was earning its highest revenue at 4 units.

As a result, you must use the firms marginal cost and marginal revenue to accurately calculate its profit
maximization. Marginal cost can be computed by calculating the increase in the total cost (column 4) from an
additional unit of output (column 1) produced. Similarly, marginal revenue can be computed by calculating the
change in total revenue (column 3) from an additional unit of output (column 1) sold. Once those values have
been computed you can compare the firms marginal cost and marginal revenue values to determine the actual
profit maximization. From the table it is evident that the firms marginal cost is less than its marginal revenue up
until the second unit is sold. However, if the firm were to produce the third unit it would cost the firm $4 while
that third unit only brought in $2 of additional revenue. Therefore, from the table we can conclude that this
monopolistic firms profit-maximizing quantity is about 2 units and its profit-maximizing price is about $5.

Once, you have a firm understanding of how the numbers in Table 11.a.1 are computed the next step is to
transfer the numbers onto a graph in Figure 11.a.1. In this figure it is evident that this firms profitmaximizing
quantity is about 2, while its profit-maximizing price is about $5 which is what consumers will be willing to pay
for 2 units. In order to calculate the profit received by this firm we need to calculate the firms average total cost
Table 11.a.1
Quantity Price Total Revenue
(P x Q)
Total
Cost
Profit
(TR - TC)
Average Total
Cost
(TC / Q)
Marginal
Cost
Marginal
Revenue
0 $7 $0 $3 $-3 $

1 6 6 5 1 5
2 5 10 8 2 4
3 4 12 12 0 4
4 3 12 17 -5 4.25
5 2 10 23 -13 4.6
6 1 6 30 -24 5
> $2
> 3
> 4
> 5
> 6
> 7
> $6
> 4
> 2
> 0
> -2
> -4
*Black numbers indicate given values, while red numbers indicate calculated values.

at every quantity by dividing the firms total cost by quantity. This is illustrated in the column 6 of Table 11.a.1.
Since we already know the profit-maximizing quantity is about 2 we just look at the average total cost value at
the quantity of 2 in the table which is $4. Now that we have all of these values we just need to plug it into the
total profit equation (P ATC) x Q which equals a total profit of $2 ((5-4) x 2). This total profit of $2 is
illustrated by the purple rectangle in Figure 11.a.1.





















Example #2:
Given the equations
Demand (D): P=50-Q and
Total Cost (TC): P=80+20Q+
Find the profit-maximizing quantity and price as well as the total profit of this monopolistic firm. Illustrate in
graphs

In order to calculate the profit maximizing quantity of a monopoly you need to find the quantity in which the
firms marginal cost equals its marginal revenue. In order to calculate the firms marginal revenue equation you
need to calculate the firms total revenue equation and then take the derivative of the firms total revenue to give
you its marginal revenue. To find the marginal cost equation you just take the derivative of its total cost
equation
TR = P x Q = (50-Q)Q = 50Q - MR = 50 2Q

MC=dTC/dQ=20+Q

Now we can set the firms marginal cost equal to its marginal revenue so that we can calculate its profit-
maximizing quantity
MC = MR
20 + Q = 50 2Q
3Q = 30
= 10
Next, you need to plug Q = 10 into the Demand equation in order to calculate the profit-maximizing price of
the monopoly
D: P = 50 10
= 40
Once you have calculated the profit maximizing quantity and price of the monopoly you need to calculate the
equation for the average total cost curve in order to compute total profit of the monopolistic firm. The average
total cost curve is computed by dividing the total cost equation by quantity. Once the firms average total cost
curve is calculated you need to plug Q = 10 into this equation in order to calculate the firms price on the
average total cost curve at the profit-maximizing quantity
ATC: P = = + 20 +
P = + 20 + = 33
Now that these values have all been calculated you can determine the total profit of this monopolistic firm
one of two ways. First, you can compute the total profit by subtracting the firms total cost from its total
revenue. Second, you can manipulate the total profit equation (TR TC) in terms of price, quantity, and average
total cost and then solve for total profit...
Total Profit = TR TC Total Profit = TR TC
= (50Q ) (80 + 20Q + ) = ( ) x Q = ( ATC) x
Q
= (50(10) ) (80 + 20(10) + ) = (P ATC) x Q
= 400 330 = (40 33) x 10
= 70 = 70
Look at Figure 11.a.2 and Figure 11.a.3 to see how all of the calculations above can be illustrated in graphs.
































Study Questions:

1. Why is a monopolys demand curve downward sloping and what affect does this have on its profit-
maximization price and quantity?
2. What should a monopoly do if its price equals its average total cost?
a. Increase output
In Figure 11.a.2 the purple triangle represents the total profit = 70 calculated above. From the graph we can see
how the equation (P ATC) x Q is used. The yellow area represents the total cost = 330 calculated above and the
two areas put together equal the total revenue (330 + 70 = 400). If you compare the two figures you can see that
the yellow rectangle in Figure 11.a.2 is represented in Figure 11.a.3 by the point on the total cost curve where it
has a quantity of 10. Also, in Figure 11.a.3 you can see what total revenue equals by looking at the point on the
total revenue curve where is has a quantity of 10. This value is represented by the purple and yellow areas
combined. Therefore, the purple area (total profit = 70) in Figure 11.a.2 can also be represented by the red line
between the total cost and total revenue curves in Figure 11.a.3. Another interesting piece of information we can
take away from Figure 11.a.3 is a proof of why a firm maximizes profits where its marginal cost equals it
marginal revenue. This figure indicates that the slopes of the total cost and total revenue (the blue lines) curves are
equal. Another name for these curves is the marginal cost and marginal revenue because the slope of the total cost
is the marginal cost while the slope of the total revenue curve is the marginal revenue. Since these lines slopes
equal at the profit-maximizing output we can conclude that a monopolistic firm operates at maximum profit
where its marginal revenue equals its marginal cost, which we achieved in Figure 11.a.2.
b. Lower its price
c. Nothing, it is making zero profits
d. Decrease output
e. Raise its price
f. It is not a monopoly
3. What should a monopoly do if its price equals its marginal cost?
a. Increase output
b. Lower its price
c. It is making zero profits
d. Decrease output
e. Raise its price
f. It is not a monopoly
4. What is characteristic of a monopolys marginal revenue curve?
a. It is the same as its demand curve
b. It decreases as quantity sold increases
c. It is a horizontal line
d. It increases as quantity sold decreases

Answers:

1. Since monopolies are the only producer in its market they are able to adjust their own prices. However,
given that they are the only firm in the market they face the market demand curve where they have to
lower prices if they want to increase output. This decrease in price from an increase in quantity
illustrates the characteristic of a downward sloping demand curve. Since monopolies face a downward
sloping demand curve their marginal revenue no longer equals their demand because the price of the
output is decreasing as more output is produced and therefore less revenue is made per extra unit of
output. To find its profit-maximization you need to go where its marginal revenue curve equals its
marginal cost curve to find the quantity and then up to its demand at that quantity to find the price.
Since the marginal revenue curve no longer equals its demand curve the price always ends up being
above the firms marginal cost curve in a monopoly, rather than equal to its marginal cost curve like a
competitive firm.
2. C. Nothing, it is making zero profits
3. F. It is not a monopoly
4. A. It decreases as quantity sold increases