Monopoly when is total surplus maximized

For this reason, governments often seek to regulate monopolies and encourage increased competition. For monopolies, marginal cost curves are upward sloping and marginal revenues are downward sloping. In traditional economics, the goal of a firm is to maximize their profits. This means they want to maximize the difference between their earnings, i. To find the profit maximizing point, firms look at marginal revenue MR — the total additional revenue from selling one additional unit of output — and the marginal cost MC — the total additional cost of producing one additional unit of output.

When the marginal revenue of selling a good is greater than the marginal cost of producing it, firms are making a profit on that product. This leads directly into the marginal decision rule, which dictates that a given good should continue to be produced if the marginal revenue of one unit is greater than its marginal cost.

Therefore, the maximizing solution involves setting marginal revenue equal to marginal cost. This is relatively straightforward for firms in perfectly competitive markets, in which marginal revenue is the same as price. Monopoly production, however, is complicated by the fact that monopolies have demand curves and MR curves that are distinct, causing price to differ from marginal revenue.

Monopoly : In a monopoly market, the marginal revenue curve and the demand curve are distinct and downward-sloping. Production occurs where marginal cost and marginal revenue intersect. Perfect Competition : In a perfectly competitive market, the marginal revenue curve is horizontal and equal to demand, or price.

The marginal cost curves faced by monopolies are similar to those faced by perfectly competitive firms. Most will have low marginal costs at low levels of production, reflecting the fact that firms can take advantage of efficiency opportunities as they begin to grow.

Marginal costs get higher as output increases. For example, a pizza restaurant can easily double production from one pizza per hour to two without hiring additional employees or buying more sophisticated equipment. When production reaches 50 pizzas per hour, however, it may be difficult to grow without investing a lot of money in more skilled employees or more high-tech ovens.

This trend is reflected in the upward-sloping portion of the marginal cost curve. The marginal revenue curve for monopolies, however, is quite different than the marginal revenue curve for competitive firms.

Monopolies have much more power than firms normally would in competitive markets, but they still face limits determined by demand for a product.

Higher prices except under the most extreme conditions mean lower sales. Therefore, monopolies must make a decision about where to set their price and the quantity of their supply to maximize profits. They can either choose their price, or they can choose the quantity that they will produce and allow market demand to set the price.

Since costs are a function of quantity, the formula for profit maximization is written in terms of quantity rather than in price. In this formula, p q is the price level at quantity q. The cost to the firm at quantity q is equal to c q.

Since revenue is represented by pq and cost is c, profit is the difference between these two numbers. As a result, the first-order condition for maximizing profits at quantity q is represented by:.

Monopolies will produce at quantity q where marginal revenue equals marginal cost. Then they will charge the maximum price p q that market demand will respond to at that quantity.

Consider the example of a monopoly firm that can produce widgets at a cost given by the following function:. The price of widgets is determined by demand:. How can we maximize this function?

In this case:. Consider the diagram illustrating monopoly competition. The key points of this diagram are fivefold. The flat perceived demand curve means that, from the viewpoint of the perfectly competitive firm, it could sell either a relatively low quantity like Ql or a relatively high quantity like Qh at the market price P.

A monopoly is a firm that sells all or nearly all of the goods and services in a given market. In , after years of legal appeals, the U. Supreme Court held that the broader market definition was more appropriate, and the case against DuPont was dismissed. Questions over how to define the market continue today. The Greyhound bus company may have a near-monopoly on the market for intercity bus transportation, but it is only a small share of the market for intercity transportation if that market includes private cars, airplanes, and railroad service.

DeBeers has a monopoly in diamonds, but it is a much smaller share of the total market for precious gemstones and an even smaller share of the total market for jewelry. In general, if a firm produces a product without close substitutes, then the firm can be considered a monopoly producer in a single market. But if buyers have a range of similar—even if not identical—options available from other firms, then the firm is not a monopoly.

Still, arguments over whether substitutes are close or not close can be controversial. No monopolist, even one that is thoroughly protected by high barriers to entry, can require consumers to purchase its product. Because the monopolist is the only firm in the market, its demand curve is the same as the market demand curve, which is, unlike that for a perfectly competitive firm, downward-sloping. Figure 1 illustrates this situation. The monopolist can either choose a point like R with a low price Pl and high quantity Qh , or a point like S with a high price Ph and a low quantity Ql , or some intermediate point.

Setting the price too high will result in a low quantity sold, and will not bring in much revenue. Conversely, setting the price too low may result in a high quantity sold, but because of the low price, it will not bring in much revenue either. The challenge for the monopolist is to strike a profit-maximizing balance between the price it charges and the quantity that it sells. See the following Clear it Up feature for the answer to this question. The demand curve as perceived by a perfectly competitive firm is not the overall market demand curve for that product.

The reason for the difference is that each perfectly competitive firm perceives the demand for its products in a market that includes many other firms; in effect, the demand curve perceived by a perfectly competitive firm is a tiny slice of the entire market demand curve. In contrast, a monopoly perceives demand for its product in a market where the monopoly is the only producer. Profits for a monopolist can be illustrated with a graph of total revenues and total costs, as shown with the example of the hypothetical HealthPill firm in Figure 2.

The total cost curve has its typical shape; that is, total costs rise and the curve grows steeper as output increases. To calculate total revenue for a monopolist, start with the demand curve perceived by the monopolist. Table 2 shows quantities along the demand curve and the price at each quantity demanded, and then calculates total revenue by multiplying price times quantity at each level of output.

In this example, the output is given as 1, 2, 3, 4, and so on, for the sake of simplicity. If you prefer a dash of greater realism, you can imagine that these output levels and the corresponding prices are measured per 1, or 10, pills. As the figure illustrates, total revenue for a monopolist rises, flattens out, and then falls. In this example, total revenue is highest at a quantity of 6 or 7. Clearly, the total revenue for a monopolist is not a straight upward-sloping line, in the way that total revenue was for a perfectly competitive firm.

The different total revenue pattern for a monopolist occurs because the quantity that a monopolist chooses to produce affects the market price, which was not true for a perfectly competitive firm. If the monopolist charges a very high price, then quantity demanded drops, and so total revenue is very low. If the monopolist charges a very low price, then, even if quantity demanded is very high, total revenue will not add up to much.

At some intermediate level, total revenue will be highest. However, the monopolist is not seeking to maximize revenue, but instead to earn the highest possible profit. Profits are calculated in the final row of the table. In the HealthPill example in Figure 2 , the highest profit will occur at the quantity where total revenue is the farthest above total cost. Of the choices given in the table, the highest profits occur at an output of 4, where profit is In the real world, a monopolist often does not have enough information to analyze its entire total revenues or total costs curves; after all, the firm does not know exactly what would happen if it were to alter production dramatically.

But a monopolist often has fairly reliable information about how changing output by small or moderate amounts will affect its marginal revenues and marginal costs, because it has had experience with such changes over time and because modest changes are easier to extrapolate from current experience.

A monopolist can use information on marginal revenue and marginal cost to seek out the profit-maximizing combination of quantity and price. The first four columns of Table 3 use the numbers on total cost from the HealthPill example in the previous exhibit and calculate marginal cost and average cost. This monopoly faces a typical upward-sloping marginal cost curve, as shown in Figure 3.

The second four columns of Table 3 use the total revenue information from the previous exhibit and calculate marginal revenue. Notice that marginal revenue is zero at a quantity of 7, and turns negative at quantities higher than 7.

It may seem counterintuitive that marginal revenue could ever be zero or negative: after all, does an increase in quantity sold not always mean more revenue? For a perfect competitor, each additional unit sold brought a positive marginal revenue, because marginal revenue was equal to the given market price. But a monopolist can sell a larger quantity and see a decline in total revenue. When a monopolist increases sales by one unit, it gains some marginal revenue from selling that extra unit, but also loses some marginal revenue because every other unit must now be sold at a lower price.

As the quantity sold becomes higher, the drop in price affects a greater quantity of sales, eventually causing a situation where more sales cause marginal revenue to be negative. A monopolist can determine its profit-maximizing price and quantity by analyzing the marginal revenue and marginal costs of producing an extra unit. If the marginal revenue exceeds the marginal cost, then the firm should produce the extra unit.

For example, at an output of 3 in Figure 3 , marginal revenue is and marginal cost is , so producing this unit will clearly add to overall profits. At an output of 4, marginal revenue is and marginal cost is , so producing this unit still means overall profits are unchanged. However, expanding output from 4 to 5 would involve a marginal revenue of and a marginal cost of , so that fifth unit would actually reduce profits.

Thus, the monopoly can tell from the marginal revenue and marginal cost that of the choices given in the table, the profit-maximizing level of output is 4. Indeed, the monopoly could seek out the profit-maximizing level of output by increasing quantity by a small amount, calculating marginal revenue and marginal cost, and then either increasing output as long as marginal revenue exceeds marginal cost or reducing output if marginal cost exceeds marginal revenue.

This process works without any need to calculate total revenue and total cost. If you find it counterintuitive that producing where marginal revenue equals marginal cost will maximize profits, working through the numbers will help.

Step 1. Remember that marginal cost is defined as the change in total cost from producing a small amount of additional output.

Step 2. As a result, the marginal cost of the second unit will be:. Step 3. Remember that, similarly, marginal revenue is the change in total revenue from selling a small amount of additional output.

Step 4. As a result, the marginal revenue of the second unit will be:. Table 4 repeats the marginal cost and marginal revenue data from Table 3 , and adds two more columns: Marginal profit is the profitability of each additional unit sold. It is defined as marginal revenue minus marginal cost. This equation is used to determine the cause of inefficiency within a market. However, if one producer has a monopoly on nails they will charge whatever price will bring the largest profit.

When equilibrium is not achieved, parties who would have willingly entered the market are excluded due to the non-market price. An example of deadweight loss due to taxation involves the price set on wine and beer. At times, policy makers will place a binding constraint on items when they believe that the benefit from the transfer of surplus outweighs the adverse impact of deadweight loss.

Deadweight loss : This graph shows the deadweight loss that is the result of a binding price ceiling. Policy makers will place a binding price ceiling when they believe that the benefit from the transfer of surplus outweighs the adverse impact of the deadweight loss.

Privacy Policy. Skip to main content. Search for:. Impacts of Monopoly on Efficiency. Reasons for Efficiency Loss A monopoly generates less surplus and is less efficient than a competitive market, and therefore results in deadweight loss. Learning Objectives Evaluate the economic inefficiency created by monopolies. Key Takeaways Key Points The monopoly pricing creates a deadweight loss because the firm forgoes transactions with the consumers.

Key Terms monopoly : A market where one company is the sole supplier. Understanding and Finding the Deadweight Loss In economics, deadweight loss is a loss of economic efficiency that occurs when equilibrium for a good or service is not Pareto optimal.

Learning Objectives Define deadweight loss, Explain how to determine the deadweight loss in a given market.