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 horizontal—i.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 characteristics—a too-small number of sellers and/or the differentiation of the competing products—are 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 price—i.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" cases—those 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 product—i.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 sell—if its objective is Maximum-profit.

o. Column (3) of Table 1 shows Total Revenue—price times quantity. Complete the four blanks in this column.

Then use Columns (2) and (3) figures to illustrate Total Revenue on Study Guide Fig. 1—i.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.

с. Notice that this demand schedule becomes price-inelastic , when price is sufficiently lowered—specifically, 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 ГД above TC. The greatest distance with ГС 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 = MC—and 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 is—and 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 $2—when 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 $2—Marginal 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.

The text notes that in geometric terms Marginal Revenue can be depicted as the slope of the Total Revenue curve.

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