Notes on Monopoly

Introduction             The term monopoly is commonly understood to mean a single seller of a valuable item (good or service).  While this view does capture the basic intuition of the nature of monopoly it can be very misleading.  Being a single seller is neither a sufficient nor a necessary condition for the possession of monopoly power.  The discussion is confused by the tendency to use the categories that have been developed in neoclassical economics to define monopoly and to fashion legislation and regulation to deal with it.            In order to understand both the question of monopoly and the anti-monopoly (anti-trust) regulatory environment, therefore, we need to understand the categories that have been development in neoclassical economics and how this has become embodied in the law and in the regulatory environment.  Once we understand this we can analyze its limitations and move beyond it. 

The neoclassical view of monopoly.             Neoclassical economics was born in 1871 with the discovery of the notion of marginal utility and the realization that the tools of marginal analysis could be applied to all aspects of economic life.  It reached its definitive level of completion in the 1930’s when the theory of perfect competition and monopoly was worked out and it is this theory that has been the basis for the current regulatory environment.  At the one extreme we have markets with very many buyers and sellers, each one of whom is a price taker.  If this is a market for a standardized good or service, each competitor selling exactly the same item (no product differentiation), and if this market is one in which buyers and sellers are very well informed about all costs and prices, and if the technology of production and the characteristics of the good or service is not changing, and if there are well defined and enforced property rights – so that there are not hidden “social costs” - (all big ifs), then we will tend to have a situation that the neoclassicals refer to as perfect competition.  In perfect competition, once a long run equilibrium has been established, the price will equal the marginal cost and both will be equal to the average cost at the lowest possible average cost.  Thus perfect competition is seen as a situation of maximal efficiency.  A competitive output is being produced at the lowest possible cost. This is frequently seen as a competitive ideal for economic policy in the sense that where it does not apply policy should take steps to promote it or simulate it (for example, by forcing the regulated company to produce at a price that is equal to marginal cost).            So our first problem with prevailing regulation is to note that perfect competition may be an inappropriate standard. It is not really a competitive situation.  It is a situation in which all competition has ceased.  No profits are earned, no innovation is taking place and there is no ignorance or bargaining in the market.   It has very little relevance to the benefits that consumers may expect to gain from real world competition.            At the other extreme, neoclassical theory identifies the monopolist as a single seller.  The single seller will maximize profits (like everyone else) by producing a

quantity for which the marginal revenue equals the marginal cost and this, obviously, implies a lower quantity and a higher price than that which would prevail under hypothetical perfect competition.  This approach leads one to infer the degree of monopoly by the number of firms (sellers) there are in an industry, by market share – the fewer the greater the degree of alleged monopoly power – or by the extent to which the seller can control the price - the elasticity of demand (but remember a seller will always raise the price as long as the elasticity is less than one (unity – 1), so even observing elasticity in this framework may be misleading).            This is our second problem with the prevailing regulation. This view of monopoly is, like the view of perfect competition just mentioned, completely static – it makes no mention of the passage of time and its effects.  At any point of time one or a few sellers may dominate the market only to be replaced over time by a more efficient competitor. Even one or a very small number of sellers can face vigorous competition over time, or the threat of competition, which may greatly reduce their control over price. 

An alternative view of monopoly                       Thinking about monopoly in the real world forces us to consider the process of competition over time.  All of the conditions of the model of perfect competition are violated in important ways that make the perfect competition standard inappropriate. In the real world competition proceeds by companies experimenting with new products, new methods of production, new resources and competing with one another vigorously for the consumers’ business by lowering prices and/or improving quality. There is no way to predict who will win the competitive struggle and today’s winner may be eclipsed tomorrow.            Understanding this leads us to a different view of monopoly and of anti-trust policy. This view sees monopoly as the power that a seller has over the price he/she can charge by virtue of special protection against competition over time. So it is all about the ability to compete and freedom of entry by actual or potential competitors. We may ask, what constitutes a real or credible barrier to entry that would protect a seller? A number have been discussed in the literature and are discussed in Armentano. In the final analysis only one remains – governmental protection.            From this perspective, monopoly power has nothing to do with the number of sellers or the size of the elasticity of demand. The only relevant consideration would be whether the seller in question has the power to prevent competitors from entering the industry and the relevant consideration for policy is whether the policy-makers can be assured of making things better for consumers.  Finally, note that the ability to price discriminate has nothing to do with monopoly per se and is a practice that is widely practiced throughout the economy with various effects.

MONOPOLY:

A market structure characterized by a single seller of a unique product with no close substitutes. This is one of four basic market structures. The other three are perfect competition, oligopoly, and monopolistic competition. As the single seller of a unique good with no close substitutes, a monopoly has no competition. The demand for output produced by a monopoly is THE market demand, which gives

monopoly extensive market control. The inefficiency that results from market control also makes monopoly a key type of market failure.Monopoly is a market in which a single firm is the only supplier of the good. Anyone seeking to buy the good must buy from the monopoly seller. This single-seller status gives monopoly extensive market control. It is a price maker. The market demand for the good sold by a monopoly is the demand facing the monopoly. Market control means that monopoly does not equate price with marginal cost and thus does not efficiently allocate resources.

CharacteristicsThe four key characteristics of monopoly are: (1) a single firm selling all output in a market, (2) a unique product, (3) restrictions on entry into the industry, and (4) specialized information about production techniques unavailable to other potential producers.

Single Supplier: First and foremost, a monopoly is a monopoly because it is the only seller in the market. The word monopoly actually translates as "one seller." As the only seller, a monopoly controls the supply-side of the market completely. If anyone wants to buy the good, they must buy from the monopoly.

Unique Product: A monopoly achieves single-seller status because the good supplied is unique. There are no close substitutes available for the good produced by a monopoly.

Barriers to Entry: A monopoly often acquires and generally maintains single seller status due to restrictions on the entry of other firms into the market. Some of the key barriers to entry are: (1) government license or franchise, (2) resource ownership, (3) patents and copyrights, (4) high start-up cost, and (5) decreasing averagetotal cost. These restrictions might be imposed for efficiencyreasons or simply for the benefit of the monopoly.

Specialized Information: A monopoly often possesses information not available to others. This specialized information comes in the form of legally-established patents, copyrights, or trademarks.

ReasonsMonopolies achieve their single-seller status for three interrelated reasons: (1) economies of scale, (2) government decree, and (3) resource ownership. While a monopoly can emerge and persist for any one of these reasons, most monopolies rely on two or all three.

Economies of Scale: Many real world monopolies emerge due to economies of scale and decreasing average cost. If average cost decreases over the entire range of demand, then a single seller can provide the good at lower per unit cost and more efficiently than multiple sellers. This often leads to what is termed a natural monopoly. The market might start with more than one seller, but it naturally ends up with a single seller that can best take advantage of decreasing average cost. Many public utilities (such as electricity distribution, natural gas distribution, garbage collection) have this natural monopoly inclination.

Government Decree: The monopoly status of a firm can be established by the mandate of government. Government simply gives one and only one firm the legal authority to supply a particular good. Such single seller legal

status is usually justified on economic grounds, such as an electric company that naturally tends to monopolize a market. However, it might also result from political forces, such as mandating monopoly status to a firm controlled by a campaign donor or close political associate.

Resource Ownership: A monopoly is likely to arise if a firm has complete control over a key input or resource used in production. If the firm controls the input, then it controls the output. Monopolies have arisen over the years due to control over material resources (petroleum and bauxite ore), labor resources (talented entertainers and skilled athletes), or information resources (patents and copyrights).

Demand and RevenueSingle-seller status means that monopoly faces a negatively-sloped demand curve, such as the one displayed in the exhibit to the right. In fact, the demand curve facing the monopoly is the market demand curve for the product.

The top curve in the exhibit is the demand curve (D) facing the monopoly. The lower curve is the marginal revenue curve (MR).

Because a monopoly is a price maker with extensive market, it faces a negatively-sloped demand curve. To sell a larger quantity of output, it must lower the price. For example, the monopoly can sell 1 unit for $10. However, if it wants to sell 2 units, then it must lower the price to $9.50.

For this reason, the marginal revenue generated from selling extra output is less than price. While the price of the second unit sold is $9.50, the marginal revenue generated by selling the second unit is only $9. While the $9.50 price means the monopoly gains $9.50 from selling the second unit, it loses $0.50 due to the lower price on the first unit ($10 to $9.50). The net gain in revenue, that is marginal revenue, is thus only $9 (= $9.50 - $0.50).

Short-Run ProductionThe analysis of short-run production by a monopoly provides insight into efficiency (or lack thereof). The key

Demand Curve,Monopoly

Short-Run Production,Monopoly

assumption is that a monopoly, like any other firm, is motivated by profit maximization. The firm chooses to produce the quantity of output that generates highest possible level of profit, given price, market demand, cost conditions, production technology, etc.

The short-run production decision for monopoly can be illustrated using the exhibit to the right. The top panel indicates the two sides of the profit decision--revenue and cost. The hump-shaped greenline is total revenue (TR). Because price depends on quantity, the total revenue curve is a hump-shaped line. The curved red line is total cost (TC). The difference between total revenue and total cost is profit, which is illustrated by the lower panel as the brownline.

A firm maximizes profit by selecting the quantity of output that generates the greatest gap between the total revenue line and the total cost line in the upper panel, or at the peak of the profit curve in the lower panel. In this example, the profit maximizing output quantity is 6. Any other level of production generates less profit.

A Few ProblemsThree problems often associated with a market controlled totally by a single firm are: (1) inefficiency, (2) income inequality, (3) political abuse.

Inefficiency: The most noted monopoly problem is inefficiency. Market control means that a monopoly charges a higher price and produces less output than would be achieved under perfect competition. In addition, and most indicative of inefficiency, the price charged by the monopoly is greater than the marginal cost of production.

Income Inequality: A lesser known problem with monopoly is an inequitable distribution of income. To the extent that monopoly earns economic profit, consumer surplus is transferred from buyers to the monopoly. Buyers end up with less income and the monopoly ends up with more. In addition, because price is greater than marginal cost and a monopoly receives economic profit, factor payments to some or all of the resources used by the monopoly are greater than their contributions to production. A portion of this economic profit is often "paid" to the owners of the labor, capital, or land.

Political Abuse: A third potential problem, one tied directly to the concentration of income by the monopoly resources, is the abuse of political power. The monopoly could use its economic profit to influence the political process, especially policies that might prevent potential competitors from entering the market.

The Other Three Market StructuresMonopoly is one of four common market structures. The other three are: perfect competition, oligopoly, andmonopolistic competition. The exhibit to the right illustrates how these four market structures form a continuum based on the relative degree of market control and the number of competitors in the market. At the far right of the market structure continuum is monopoly, characterized by a single seller and extensive market control.

Market Structure Continuum

Perfect Competition: To the far left of the market structure continuum is perfect competition, characterized by a large number of relatively small competitors, each with no market control. Perfect competition is an idealized market structure that provides a benchmark for efficiency.

Oligopoly: In the middle of the market structure continuum, residing closer to monopoly, is oligopoly, characterized by a small number of relatively large competitors, each with substantial market control. A substantial number of real world markets fit the characteristics of oligopoly.

Monopolistic Competition: Also in the middle of the market structure continuum, but residing closer to perfect competition, is monopolistic competition, characterized by a large number of relatively small competitors, each with a modest degree of market control. A substantial number of real world markets fit the characteristics of monopolistic competition.

ONOPOLY AND PERFECT COMPETITION:

Monopoly and perfect competition represent two extremes along a continuum of market structures. At the one extreme is perfect competition, representing the ultimate of efficiency achieved by an industry that has extensive competition and no market control. Monopoly, at the other extreme, represents the ultimate of inefficiency brought about by the total lack of competition and extensive market control.Monopoly is a market structure with complete market control. As the only seller in the market, a monopoly controls the supply-side of the market. Perfect competition, in contrast, is a market structure in which each firmhas absolutely no market control. No firm in perfect competition can influence the market price in any way.

The best way to compare monopoly and perfect competition is the four characteristics of perfect competition: (1) large number of relatively small firms, (2) identical product, (3) freedom of entry and exit, and (4) perfect knowledge.

Number of Firms: Perfect competition is an industry comprised of a large number of small firms, each of which is a price taker with no market control. Monopoly is an industry comprised of a single firm, which is a price maker with total market control. Phil the zucchini grower is one of gadzillions of zucchini growers. Feet-First Pharmaceutical is the only firm that sells Amblathan-Plus, a drug that cures the deadly (but hypothetical) foot ailment known as amblathanitis.

Available Substitutes: Every firm in a perfectly competitive industry produces exactly the same product as every other firm. An infinite number of perfect substitutes are available. A monopoly firm produces a unique product that has no close substitutes and is unlike any other product. Gadzillions of firms grow zucchinis, each of which is a perfect substitute for the zucchinis grown by Phil the zucchini grower. There are no substitutes for Amblathan-Plus. Feet-First Pharmaceutical is the only supplier.

Resource Mobility: Perfectly competitive firms have complete freedom to enter the industry or exit the industry. There are no barriers. A monopoly firm often achieves monopoly status because the entry of potential

competitors is prevented. Anyone can grow zucchinis. All they need is a plot of land and a few seeds. Feet-First Pharmaceutical holds the patents on Amblathan-Plus. No other firm can enter the market.

Information: Each firm in a perfectly competitive industry possesses the same information about prices and production techniques as every other firm. A monopoly firm, in contrast, often has information unknown to others. Everyone knows how to grow zucchinis (or can easily find out how). Feet-First Pharmaceutical has a secret formula used in the production of Amblathan-Plus. This information is not available to anyone else.

The consequence of these differences include: First, the demand curve for a perfectly competitive firm is perfectly

elastic and the demand curve for a monopoly firm is THE market demand, which is negatively-sloped according to the law of demand. A perfectly competitive firm is thus a price taker and a monopoly is a price maker. Phil must sell his zucchinis at the going market price. It he does not like the price, then he does not sell zucchinis. Feet-First Pharmaceutical can adjust the price of Amblathan-Plus, either higher or lower, and so doing it can control the quantity sold.

Second, the monopoly firm charges a higher price and produces less output than would be achieved with a perfectly competitive market. In particular, the monopoly price is not equal to marginal cost, which means a monopoly does not efficiently allocate resources. Although Feet-First Pharmaceutical charges several dollars per ounce of Amblathan-Plus, the cost of producing each ounce is substantially less. Phil, in contrast, just about breaks even on each zucchini sold.

Third, while an economic profit is NOT guaranteed for any firm, a monopoly is more likely to receive economic profit than a perfectly competitive firm. In fact, a perfectly competitive firm IS guaranteed to earn nothing but a normal profit in the long run. The same cannot be said for monopoly. The price of zucchinis is so close to the cost of production, Phil never earns much profit. If the price is relatively high, other zucchini producers quickly flood the market, eliminating any profit. In contrast, Feet-First Pharmaceutical has been able to maintain a price above production cost for several years, with a handsome profit perpetually paid to the company shareholders year after year.

Fourth, the positively-sloped marginal cost curve for each perfectly competitive firm is its supply curve. This ensures that the supply curve for a perfectly competitive market is also positively sloped. The marginal cost curve for a monopoly is NOT, repeat NOT, the firm's supply curve. There is NO positively-sloped supply curve for a market controlled by a monopoly. A monopoly might produce a larger quantity if the price is higher, in accordance with the law of supply, or it might not. If the price of zucchinis rises, then Phil can afford to grow more. If the price falls, then he is forced to grow less. Marginal cost dictates what Phil can produce and supply. Feet-First Pharmaceutical, in comparison, often sells a larger quantity of Amblathan-Plus as the price falls, because they face decreasing average cost with larger scale production.

MONOPOLY, CHARACTERISTICS:

The four key characteristics of monopoly are: (1) a single firm selling all output in a market, (2) a unique product, (3) restrictions on entry into and exit out of the industry, and more often than not (4) specialized information about production techniques unavailable to other potential producers.These four characteristics mean that a monopoly has extensive (boarding on complete) market control. Monopoly controls the selling side of the market. If anyone seeks to acquire the production sold by the monopoly, then they must buy from the monopoly. This means that the demand curve facing the monopoly is the market demand curve. They are one and the same.

The characteristics of monopoly are in direct contrast to those of perfect competition. A perfectly competitive industry has a large number of relatively small firms, each producing identical products. Firms can freely move into and out of the industry and share the same information about prices and production techniques.

A monopolized industry, however, tends to fall far short of each perfectly competitive characteristic. There is one firm, not a lot of small firms. There is only one firm in the market because there are no close substitutes, let alone identical products produced by other firms. A monopoly often owes its monopoly status to the fact that other potential producers are prevented from entering the market. No freedom of entry here. Neither is there perfect information. A monopoly firm often has specialized information, such as patents or copyrights, that are not available to other potential producers.

Single SupplierThe essence of a monopoly is a market controlled by a single seller. The "mono" part of monopoly means single. This "mono" term is also the source of such words as monarch--a single ruler; monochrome--a single color; monk--a solitary religious figure; monocle--an eyeglass for one eye; and monolith--a single large stone. The "poly" part of monopoly means to sell. So the word itself, monopoly, means a single seller.

The single seller, of course, is a direct contrast to perfect competition, which has a large number of sellers. In fact, perfect competition could be renamed multipoly or manypoly, to contrast it with monopoly. The most important aspect of being a single seller is that the monopoly seller IS the market. The market demand for a good IS the demand for the output produced by the monopoly. This makes monopoly a price maker, rather than a price taker.

A hypothetical example that can be used to illustrate the features of a monopoly is Feet-First Pharmaceutical. This firm owns the patent to Amblathan-Plus, the only cure for the deadly (but hypothetical) foot ailment known as amblathanitis. As the only producer of Amblathan-Plus, Feet-First Pharmaceutical is a monopoly with extensive market control. The market demand for Amblathan-Plus is THE demand for Amblathan-Plus sold by Feet-First Pharmaceutical.

Unique ProductTo be the only seller of a product, however, a monopoly must have a unique product. Phil the zucchini grower is the only producer of Phil's zucchinis. The problem for Phil, however, is that gadzillions of other firms sell zucchinis that are indistinguishable from those sold by Phil.

Amblathan-Plus, in contrast, is a unique product. There are no close substitutes. Feet-First Pharmaceutical holds the exclusive patent on Amblathan-Plus. No other

firm has the legal authority to produced Amblathan-Plus. And even if they had the legal authority, the secret formula for producing Amblathan-Plus is sealed away in an airtight vault deep inside the fortified Feet-First Pharmaceutical headquarters.

Of course, other medications exist that might alleviate some of the symptoms of amblathanitis. One ointment temporarily reduces the swelling. Another powder relieves the redness. But nothing else exists to cure amblathanitis completely. A few highly imperfect substitutes exists. But there are no close substitutes for Amblathan-Plus. Feet-First Pharmaceutical has a monopoly because it is the ONLY seller of a UNIQUE product.

Barriers to Entry and ExitA monopoly is generally assured of being the ONLY firm in a market because of assorted barriers to entry. Some of the key barriers to entry are: (1) government license or franchise, (2) resource ownership, (3) patents and copyrights, (4) high start-up cost, and (5) decreasingaverage total cost.

Feet-First Pharmaceutical has a few these barriers working in its favor. It has, for example, an exclusive patent on Amblathan-Plus. The government has decreed that Feet-First Pharmaceutical, and only Feet-First Pharmaceutical, has the legal authority to produce and sell Amblathan-Plus.

Moreover, the secret ingredient used to produce Amblathan-Plus is obtained from a rare, genetically enhanced, eucalyptus tree grown only on a Brazilian plantation owned by Feet-First Pharmaceutical. Even if another firm knew how to produce Amblathan and had the legal authority to do so, they would lack access to this essential ingredient.

A monopoly might also face barriers to exiting a market. If government deems that the product provided by the monopoly is essential for well-being of the public, then the monopoly might be prevented from leaving the market. Feet-First Pharmaceutical, for example, cannot simply cease the production of Amblathan-Plus. It is essential to the health and welfare of the public.

This barrier to exit is most often applied to public utilities, such as electricity companies, natural gas distribution companies, local telephone companies, and garbage collection companies. These are often deemed essential services that cannot be discontinued without permission from a government regulation authority.

Specialized InformationMonopoly is commonly characterized by control of information or production technology not available to others. This specialized information often comes in the form of legally-established patents, copyrights, or trademarks. While these create legal barriers to entry they also indicate that information is not perfectly shared by all. The AT&T telephone monopoly of the late 1800s and early 1900s was largely due to the telephone patent. Pharmaceutical companies, like the hypothetical Feet-First Pharmaceutical, regularly monopolize the market for a specific drug by virtue of a patent.

In addition, a monopoly firm might know something or have a piece of information that is not available to others. This "something" may or may not be patented or copyrighted. It could be a secret recipe or formula. Perhaps it is a unique method of production.

One example of specialized information is the special, secret formula for producing Amblathan-Plus that is sealed away in an airtight vault deep inside the

fortified Feet-First Pharmaceutical headquarters. No one else has this information. 

MONOPOLY, DEMAND:

The demand for the output produced by a monopoly is THE market demand for the good. In particular, if the market demand curve is negatively sloped (in accordance with the law of demand), then the demand curve for the output produced by a monopoly is also negatively sloped. The monopoly IS the market. The market demand IS the monopoly's demand. They are one and the same.Monopoly is a market in which a single firm is the only supplier of the good. Anyone seeking to buy the good must buy from the monopoly seller. This single-seller status gives monopoly extensive market control; it is a price maker. The market demand for the good sold by a monopoly is the demand facing the monopoly.

Feet-First PharmaceuticalA hypothetical example that can be used to illustrate the demand for a monopoly is Feet-First Pharmaceutical. This firm owns the patent to Amblathan-Plus, the only cure for the deadly (but hypothetical) foot ailment known as amblathanitis. As the only producer of Amblathan-Plus, Feet-First Pharmaceutical is a monopoly with extensive market control. As such the market demand for Amblathan-Plus is also THE demand for Amblathan-Plus sold by Feet-First Pharmaceutical.

Demand and RevenueSingle-seller status for Feet-First Pharmaceutical means that it faces a negatively-slopeddemand curve, such as the one displayed in the exhibit to the right. The demand curve facing any monopoly is the market demand curve for the product.

The top curve in the exhibit is the demand curve (D) for Amblathan-Plus. This demand curve is also the average revenue curve for Amblathan-Plus. It shows the per unit revenue received by Feet-First Pharmaceutical for the sale of Amblathan-Plus. For reference purposes, the lower curve is the marginal revenue curve (MR). This curve displays the extra revenue received by Feet-First Pharmaceutical for each extra ounce of Amblathan-Plus sold.

Because a monopoly is a price maker with extensive market control, it faces a negatively-sloped demand curve. To sell a larger quantity of output, it must lower the price. For example, the Feet-First Pharmaceutical can sell 1 ounce of Amblathan-Plus for $10. However, if it wants to sell 2 ounces, then it must lower the price to $9.50. If it seeks to sell 3 ounces, then the price must be lowered to $9. Larger quantities are only sold it the price is less.

For this reason, the marginal revenue generated from selling extra output is less than price. While the price of the second ounce sold of Amblathan-Plus is $9.50, the marginal revenue generated by selling the second ounce is only $9. While the $9.50 price means the monopoly gains $9.50 from selling the second ounce, it

Demand Curve,Monopoly

loses $0.50 due to the lower price on the first ounce ($10 to $9.50). The net gain in revenue, that is marginal revenue, is thus only $9 (= $9.50 - $0.50).

By similar reasoning, the marginal revenue generated by the third ounce of Amblathan-Plus is only $8, even though the price is $9. On the plus side, Feet-First Pharmaceutical receives $9 from selling the third ounce. However, to sell the third ounce, it must lower the price on the first two ounces from $9.50 to $9. It loses $0.50 on each of these two ounces, or a total loss of $1. As such, the net gain in revenue, marginal revenue, is only $8 (= $9 - $1).

Compared to Perfect CompetitionThe demand facing monopoly can be compared with the demand facing a perfectly competitive firm. The demand curve for the output produced by a perfectly competitive firm is perfectly elastic, it is horizontal at the going market price. This is what makes a perfectly competitive firm a price taker. It must "take" whatever price is set in the overall market. Facing a downward-sloping demand curve, however, makes a monopoly a price maker. It has a great deal of control over the market and the market price. It IS the market!

Consider the market demand curve for the hypothetical Amblathan-Plus pharmaceutical foot treatment. This market demand curve indicates that if the market price is $4 per ounce, then Amblathan-Plus buyers are willing and able to purchase 2,000 ounces of medicine. If the price is $1 per ounce, then they are willing and able to purchase 8,000 ounces.

The first task is to compare this market demand curve for the demand curve facing Feet-First Pharmaceutical. To make this comparison, click the [Monopoly] button. Notice that NOTHING HAPPENS. It is the same curve. But of course! The market is the monopoly, the monopoly is the market.

The next task is a comparison with perfect competition. Suppose the market for Amblathan-Plus is transformed into a perfectly competitive market, with thousands of different firms selling Amblathan-Plus. How does the demand curve facing one of the perfectly competitive firms selling this medicine compare to the monopoly demand? Click the [Perfect Competition] button to illustrate. The resulting curve is horizontal, or perfectly elastic. Also note that the horizontal quantity scale measurement changes from thousands of ounces to mere ounces. Each of the perfectly competitive firms is now a price taker, and the price they take is $2.50 per ounce.

MONOPOLY, EFFICIENCY:

A monopoly generally produces less output and chargers a higher price than would be the case for perfect competition. In particular, the price charged by a monopoly is higher than the marginal cost of production, which violates the efficiency condition that price equals marginal cost. Monopoly is inefficient because it has market control and faces a negatively-sloped demand curve.

Demand,Monopoly versus

Perfect Competition

Monopoly does not efficiently allocate resources. In fact, monopoly (if left unregulated) is generally considered the most inefficient of the four market structures. The reason for this inefficiency is found with market control. As the only seller in the market, the negatively-sloped market demand curve is THE demand curve facing the monopoly. If buyers want to buy, they must buy from the monopoly.

The negative slope of the demand curve means that the price charged by the monopoly is greater than marginal revenue. As a profit-maximizing firm that equates marginal revenue with marginal cost, the price charged by monopoly is greater than marginal cost. The inequality between price and marginal cost is what makes monopoly inefficient.

Profit MaximizationConsider the production and sale of Amblathan-Plus, the only cure for the deadly (but hypothetical) foot ailment known as amblathanitis. This drug is produced by the noted monopoly firm, Feet-First Pharmaceutical.

A typical profit-maximizing output determination using the marginal revenue and marginal cost approach is presented in this diagram. Feet-First Pharmaceutical maximizes profit by producing output that equates marginal revenue and marginal cost, which is 6 ounces of Amblathan-Plus in this example. The corresponding price charged is $7.50.

This profit-maximizing production is not efficient. In particular, the price is $7.50, but the marginal cost is only $4.50. Society is producing and consuming a good that it values at $7.50 (the price). However, in so doing, society is using resources that could have produced other goods valued at $4.50 (the marginal OPPORTUNITY cost). Society gives up $4.50 worth of value and receives $7.50.

This is a good thing. It is so good, that society should do more. However, the monopoly is not letting this happen. Feet-First Pharmaceutical is not devoting as many resources to the production of Amblathan-Plus as society would like.

An Efficient AlternativeThe degree of monopoly inefficiency can be illustrated with a comparison to perfect competition. Such a comparison is easily accomplished by clicking the [Perfect Competition] button. A primary use of perfect competition is to provide a benchmark for the comparison with other market structures, such as monopoly.

A comparison between monopoly and perfect competition indicates:

Monopoly produces less output than perfect competition. In this example, monopoly produces 6 ounces of Amblathan-Plus compared to about 7.5 ounces for perfect competition. The Feet-First Pharmaceutical monopoly does not allocate enough resources to the production of Amblathan-Plus.

Inefficiency

Monopoly charges a higher price than perfect competition. In this example, the monopoly price is $7.50 per ounce versus about $6.75 per ounce for perfect competition. The Feet-First Pharmaceutical monopoly is NOT efficient because it produces at a quantity in which price is greater than marginal cost.

MONOPOLY, FACTOR MARKET ANALYSIS:

The analysis of a factor market characterized by monopoly indicates that the single seller maximizes profit by equating marginal revenue to marginal cost. This results in a higher price and smaller quantity than achieved with perfect competition. As such, it does not achieve an efficient allocation of resources. Monopoly is combined with monopsony to form a bilateral monopoly market structure.Monopoly is a market characterized by a single firm selling a unique product with few if any close substitutes. Competition is commonly prevented by barriers to entry into the market. These characteristics mean monopoly is a price maker with complete market control. Monopoly is most commonly analyzed in terms of output or product markets in which business firms are the producers and household consumers are the buyers. However, monopoly also can be used to analyze resource or factor markets.

When monopoly is applied to a factor market, the only difference is that the good sold is the services of a factor of production rather than a traditional consumption good. However, the inefficiency found with monopoly rings just as strong with factor markets as with product markets. Monopoly is the poster child for inefficiency, whether it controls a product market or a factor market. The price charged by a monopoly is higher and the quantity exchanged is less than would be had by perfect competition.

Monopoly Cost and RevenueAn example that can illustrate a monopoly factor market is provided by the United Tree Choppers Union. This hypothetical labor union controls the supply-side of the factor market for the tree chopping labor services. If any of the thousands of prospective employers want to hire tree chopping labor services, they must go through the United Tree Choppers Union.

As such, the United Tree Choppers Union is a monopoly seller and a price maker when it comes to selling tree chopping labor services. The Choppers Union can set the quantity of labor services, then charge the price that employers are willing and able to pay.

This diagram displays the market for labor services supplied by the Choppers Union. The vertical axis measures the factor price (wage rate) and the horizontal axis measures the quantity of labor services (number of workers). The key for any monopoly seller like the Choppers Union, is that the demand curve it faces for selling labor is THE market demand curve for the factor.

Tree Chopping Employment

Demand: To identify the labor demand curve facing the Choppers Union, click the [Demand]. The resulting curve, labeled D, is negatively sloped, indicating that potential employers are willing to pay a lower wage to increase the quantity hired. More to the point, if the Choppers Union wants to sell more labor services, it must accept a lower wage. This demand curve is also the average revenue curve for the Choppers Union.

Marginal Revenue: Because the Choppers Union charges a lower wage (average revenue) to sell more labor, marginal revenue is less than average revenue at each level of employment. Marginal revenue is the key bit of information the Choppers Union needs to sell the profit maximizing number of workers. To identify the marginal revenue curve, click the [Marginal Revenue] button. The revealed curve, labeled MR, is also negatively sloped and lies below the demand (average revenue) curve.

Marginal Cost: The other half of the Choppers Union's profit-maximizing decision is marginal cost. Marginal cost indicates the change in total cost resulting from the employment of one additional worker. A click of the [Marginal Cost] button reveals the Choppers Union's marginal cost curve, labeled MC. This curve is positively-sloped because marginal cost is based on marginal product which declines with extra employment due to of the law of diminishing marginal returns.

Profit Maximizing EmploymentAll of the information needed to identify the quantity of workers that would maximize the Choppers Union's profit (that is, the total income of the union members) is in hand. The profit-maximizing employment is the quantity that equates marginal revenue and marginal cost, which is the intersection of the MR and MC curves. Click the [Profit Max] button to highlight this quantity. The profit-maximizing quantity of employment is 30,000 workers.

Why is this profit maximization?

Should the Choppers Union sell the services of fewer than 30,000 workers, then marginal revenue is greater than marginal cost. An extra worker generates more revenue for the union than it adds to cost. This increases the Choppers Union's profit. The Choppers Union should sell more labor services if marginal revenue exceeds marginal cost.

Should the Choppers Union sell the services of more than 30,000 workers, then marginal revenue is less than marginal cost. An extra worker contributes less to revenue for the union than it adds to cost. This decreases the Choppers Union's profit. The Choppers Union should sell fewer labor services if marginal revenue is less than marginal cost.

Should the Choppers Union sell the services of exactly 30,000 workers, then marginal revenue is equal to marginal cost. An extra worker contributes as much to revenue as to cost. This keeps the Choppers Union's profit constant. The Choppers Union should not change the quantity of labor services sold if marginal revenue is equal to marginal factor.

Once the Choppers Union identifies the profit-maximizing level of labor services to sell, the final step is to determine how much to charge for each worker. This information is found on the market demand curve (D). According to the market demand, a wage of $15 is sufficient for prospective employers to hire 30,000 workers. Because the Choppers Union is a monopoly, it needs to charge no less than this wage.

(In)EfficiencyAs a profit-maximizing monopoly with market control, the United Tree Choppers Union does not achieve an efficient allocation of resources. This results because marginal cost is not equal to the factor price. While the Choppers Union charges a factor price of $15 per hour, marginal cost is $7.50 per hour.

This difference between factor price and marginal cost is a prime indicator of inefficiency. Factor price is the value of the good produced. Marginal cost is the opportunity cost of production, the value of goods not produced. If the two are equal, then the value of the good produced is equal to the value of goods not produced. Society cannot generate more overall satisfaction by producing more or less of the good.

However, for a monopoly like the United Tree Choppers Union, marginal cost is less than factor price. In this case the value of the good produced is greater than the value of goods not produced. Society can generate more overall satisfaction by producing more of the good.

Because profit maximization means marginal revenue is equal to marginal cost, and because marginal revenue is less than factor price, marginal cost is also less than factor price for monopoly. A profit-maximizing monopoly does not, will not, cannot, efficiently allocate resources.

MONOPOLY, LOSS MINIMIZATION:

A monopoly is presumed to produce the quantity of output that minimizes economic loss, if price is greater than average variable cost but less than average total cost. This is one of three short-run production alternatives facing a firm. The other two are profit maximization (if price exceeds average total cost) and shutdown (if price is less than average variable cost).A monopoly guided by the pursuit of profit is inclined to produce the quantity of output that equates marginal revenue and marginal cost in the short run, even if it is incurring an economic loss. The key to this loss minimization production decision is a comparison of the loss incurred from producing with the loss incurred from not producing. If price exceedsaverage variable cost, then the firm incurs a smaller loss by producing than by not producing.

One of Three AlternativesLoss minimization is one of three short-run productionalternatives facing a monopoly. All three are displayed in the table to the right. The other two areprofit maximization and shutdown.

With profit maximization, price exceeds average total cost at the quantity that equates marginal revenue and marginal cost. In this case, the firm generates an economic profit.

Production Alternatives

Price and Cost Result

P > ATC Profit Maximization

ATC > P > AVC Loss Minimization

P < AVC Shutdown

With shutdown, price is less than average variable cost at the quantity that equates marginal revenue and marginal cost. In this case, the firm incurs a smaller loss by producing no output and incurring a loss equal to total fixed cost.

Amblathan-Plus ProductionThe marginal approach to analyzing a monopoly's short-run production decision can be used to identify the economic loss alternative. The exhibit displayed here illustrates the short-run production decision by Feet-First Pharmaceutical, the monopoly producer of Amblathan-Plus, the only cure for the deadly (but hypothetical) foot ailment known as amblathanitis.

The three U-shaped cost curves used in this analysis provide all of the information needed on the cost side of the firm's decision. The demand curve facing the firm (which is also the firm's average revenue curve) and the corresponding marginal curve provide all of he information needed on the revenue side.

For the time being, Feet-First Pharmaceutical maximizes profit by producing 6 ounces of Amblathan-Plus and charges a price of $7.50. This profit-maximizing situation depends on the existing market demand conditions. However, should this demand change, then maximizing a positive profit is not the primary concern of Feet-First Pharmaceutical. Its decision turns to minimizing loss. Click the [Less Demand] button to illustrate the situation facing Feet-First Pharmaceutical with a decrease in demand.

As the demand shifts leftward, the marginal revenue curve also shifts leftward. The new profit-maximizing intersection between marginal cost and marginal revenue is at 5 ounces of Amblathan-Plus. The price Feet-First Pharmaceutical charges for this quantity of production is then $6.25.

The key is that this new, lower price is between the average total cost curve and the average variable cost curve. This means that Feet-First Pharmaceutical does not generate enough revenue per ounce of Amblathan-Plus sold (average revenue = $6.25) to cover the cost of producing each ounce of Amblathan-Plus (average total cost = $6.60).

Feet-First Pharmaceutical clearly incurs an economic loss on each ounce of Amblathan-Plus produced and sold. In fact, if Feet-First Pharmaceutical produces 5 ounces of Amblathan-Plus, then its total cost is $33, but its total revenue is only $31.25. It incurs an economic loss of $1.75, a loss of $0.35 per ounce produced.

The Short-Run ChoicePerhaps Feet-First Pharmaceutical should stop producing. Perhaps it would be better off by NOT selling Amblathan-Plus. Unfortunately, Feet-First Pharmaceutical is faced with short-run fixed cost. Feet-First Pharmaceutical incurs a total fixed cost of $10 whether or not it engages in any short-run production. Even if it shuts down production, it still must pay this $10 of fixed cost.

Profit and Loss

As such, Feet-First Pharmaceutical is faced with a comparison between the loss incurred from producing with the loss incurred from not producing. Those are its two short-run choices. If it produces, it incurs a loss of $1.75. If it does not produce, it incurs a loss of $10.

The choice seems relatively obvious: Feet-First Pharmaceutical is better off producing 5 ounces of Amblathan-Plus, incurring an economic loss of $1.75, and hoping for an increase in the price.

Feet-First Pharmaceutical continues producing in the short run because it generates enough revenue to pay ALL of its variable cost, plus a portion of its fixed cost. By producing 5 ounces of Amblathan-Plus, it generates $31.25 of total revenue. While this revenue falls short of covering the $33 of total cost entirely, it is enough to pay the $23 of total variable cost, with an extra $8.25 left over to pay a portion of the $10 total fixed cost. This is why the economic loss from production is less than total fixed cost.

Even though Feet-First Pharmaceutical has complete control of the supply-side of the market, it is still subject to the whims of the demand-side of the market. This $6.25 Amblathan-Plus price generates sufficient total revenue for Feet-First Pharmaceutical to pay ALL variable cost and some fixed cost. However, should this demand drop, then Feet-First Pharmaceutical would have to reevaluate its production decision. If the demand declines enough, Feet-First Pharmaceutical is forced to shut down production in the short run.

MONOPOLY, MARGINAL ANALYSIS:

A monopoly produces the profit-maximizing quantity of output that equates marginal revenue and marginal cost. This marginal approach is one of three methods that used to determine the profit-maximizing quantity of output. The other two methods involve the direct analysis of economic profit or a comparison of total revenue and total cost.Monopoly is a market in which a single firm is the only supplier of the good. Anyone seeking to buy the good must buy from the monopoly seller. This single-seller status gives monopoly extensive market control--a price maker that faces a negatively-sloped demand curve. With this negatively-sloped demand curve, marginal revenue is less than average revenue and price.

Comparable to any profit-maximizing firm, a monopoly produces the quantity of output in the short run that generates the maximum difference between total revenue and total cost, which is economic profit. This profit maximizing level of production is also achieved by the equality between marginal revenue and marginal cost. At this production level, the firm cannot increase profit by changing the level of production. The analysis of marginal revenue and marginal cost can be achieved through a table of numbers or with marginal revenue and marginal cost curves.

Working the NumbersA monopoly is presumed to produce the quantity of output that maximizes economic profit--the difference between total revenue and total cost. This decision can be analyzed using the exhibit below. This table presents revenue and cost information for Feet-First Pharmaceutical, a hypothetical example of a monopoly, for the production and sale of Amblathan-Plus, the only cure for the deadly (but hypothetical) foot ailment known as amblathanitis.

Because Feet-First Pharmaceutical produces a unique product it has extensive market control and sells its Amblathan-Plus according to the market demand. To

sell a larger quantity, it must lower the price. Feet-First Pharmaceutical's status as a monopoly firm is reflected in this table.

Quantity: The quantity of output produced by the Feet-First Pharmaceutical, presented in the first column, ranges from 0 to 12 ounces of Amblathan-Plus. While, Feet-First Pharmaceutical could produce more than 12 ounces, this range is sufficient for the present analysis.

Price: The second column presents the price received by Feet-First Pharmaceutical for selling Amblathan-Plus. As a price maker, the first and second columns represent the market demand for Amblathan-Plus. The price Feet-First Pharmaceutical faces ranges from a high of $10.50 per ounce for a zero quantity to a low of $4.50 per ounce for 12 ounces. Feet-First Pharmaceutical can sell a larger quantity of Amblathan-Plus, but only by reducing the price. Feet-First Pharmaceutical is a price maker.

Total Revenue: Total revenue is presented in the third column. This indicates the revenue Feet-First Pharmaceutical receives at each level of Amblathan-Plus production. It is derived as the quantity in the first column multiplied by the price in the second column. Total revenue ranges from $0 if no output is sold to a high of $55 for selling 10 or 11 ounces of Amblathan-Plus. For example, selling 4 ounces of Amblathan-Plus generates $34 of revenue and selling 7 ounces leads to $49 of revenue.

Total Cost: The fifth column presents the total cost incurred by Feet-First Pharmaceutical in the production of Amblathan-Plus, ranging from a low of $10 for zero output (which is fixed cost) to a high of $117 for 12 ounces. Total cost continues to rise beyond 12 ounces, but this information is not needed. Producing 1 ounce of Amblathan-Plus incurs a total cost of $17. Producing 2 ounces of Amblathan-Plus incurs a total cost of $22. Total cost rises as Feet-First Pharmaceutical produces more.

Profit: The seventh column at the far right of the table displays economic profit, the difference between total revenue in the third column and total cost in the fifth column. It starts at -$10, rises to $8, then falls to -$63.

The task is to determine which Amblathan-Plus production level provides the maximum profit using marginal revenue and marginal cost. The process goes something like this:

1. Marginal revenue indicates how much total revenue changes by producing one more or one less unit of output.

2. Marginal cost indicates how much total cost changes by producing one more or one less unit of output.

3. Profit increases if marginal revenue is greater than marginal cost and profit decreases if marginal revenue is less than marginal cost.

The Amblathan-Plus Numbers

4. Profit neither increases nor decreases if marginal revenue is equal to marginal cost.

5. As such, the production level that equates marginal revenue and marginal cost is profit maximization.

The fourth and sixth columns are reserved for these two marginal measures. To display the numbers, click the [Marginals] button.

Marginal Revenue: The fourth column displays marginal revenue, which declines from a high of $10 per ounce for the first ounce of Amblathan-Plus to a low of -$1 per ounce for the twelfth ounce. Because Feet-First Pharmaceutical is a monopoly with market control, marginal revenue is less than price.

Marginal Cost: The sixth column presents the marginal cost that Feet-First Pharmaceutical incurs in the short run for the production of Amblathan-Plus. It starts at $7, declines to a low of $3.50, then rises to $25. The declining values are the result of increasing marginal returns and the rising values are due to decreasing marginal returns and the law of diminishing marginal returns.

How can these marginals be used to identify the profit-maximizing output level? First, a quick look at the profit column indicates that the profit-maximizing

production is 6 ounces of Amblathan-Plus, which generates a profit of $8. Click the [Profit Max] button to highlight this result.

Second, with this outcome highlighted, note the corresponding marginal revenue and marginal cost values. Marginal revenue is $5 for the sixth ounce of Amblathan-Plus production and marginal cost is $4.

Feet-First Pharmaceutical increases production from 5 ounces to 6 ounces because doing so generates $5 of extra revenue and incurs only $4 of extra cost, meaning profit increases by $1 over the production of 5 ounces. Feet-First Pharmaceutical does not increase production from 6 ounces to 7 ounces because doing so generates only $4 of extra revenue but incurs $5 of extra cost, meaning profit decreases by $1.

As such, Feet-First Pharmaceutical settles in with the production and 6 ounces of Amblathan-Plus and achieves maximum profit. It cannot increase profit by changing production.

Third, while marginal revenue and marginal cost might not appear to be equal for the profit-maximizing 6 ounces of Amblathan-Plus production ($5 versus $4), they really are. The reason is that the marginal numbers in the table actually represent discrete changes from one ounce to the next. Reducing the size of the discrete change, say from 5.9999 ounces to 6 ounces, results in marginal revenue and marginal cost that are actually closer to $4.50. At the limit of an infinitesimally small change, marginal revenue and marginal cost are exactly $4.50.

While the equality between marginal revenue and marginal cost shows up better in a graph, the best practical method of identifying similar results, with a table of numbers, is to average the discrete changes on either side of the quantity. For example, the marginal cost AT the sixth ounce of Amblathan-Plus production is the average of the change from 5 to 6 ($4) and from 6 to 7 ($5), which is $4.50. Marginal revenue AT the sixth ounce

is the average of the change from 5 to 6 ($5) and from 6 to 7 ($4), which is also $4.50.

Working the CurvesThe short-run production decision for a monopoly can be graphically illustrated using marginal revenue and marginal cost curves. The exhibit to the right is standing poised to display these curves.

Average Revenue: First up is the average revenue curve, which can be seen with a click of the [Average Revenue] button. Because Feet-First Pharmaceutical is a monopoly, this average revenue curve is the market demand curve for Amblathan-Plus, which is negatively-sloped due to the law of demand.

Marginal Revenue: A click of the [Marginal Revenue] button reveals the greenline labeled MR that depicts the marginal revenue Feet-First Pharmaceutical receives from Amblathan-Plus production. Because Feet-First Pharmaceutical is a price maker, this marginal revenue curve is also a negatively-sloped line, and it lies beneath the average revenue (market demand) curve.

Marginal Cost: A click of the [Marginal Cost] button reveals a red U-shaped curve labeled MC that represents the marginal cost Feet-First Pharmaceutical incurs in the production of Amblathan-Plus. The shape is based on increasing, then decreasing marginal returns.

The key for Feet-First Pharmaceutical is to identify the production level that gives the greatest level of economic profit. Profit is maximized at the quantity of output found at the intersection of the marginal revenue and marginal cost curves, which is 6 ounces of Amblathan-Plus. Click the [Profit Max] button to highlight this production level.

To demonstrate why the equality between marginal revenue and marginal cost is the profit-maximizing production level, consider what results if marginal revenue is not equal to marginal cost:

If marginal revenue is greater than marginal cost, as is the case for small quantities of output, then the firm can increase profit by increasing production. Extra production adds more to revenue than to cost, so profit increases.

If marginal revenue is less than marginal cost, as is the case for large quantities of output, then the firm can increase profit by decreasing production. Reducing production reduces revenue less than it reduces cost, so profit increases.

The Amblathan-Plus Curves

If marginal revenue is equal to marginal cost, then the firm cannot increase profit by producing more or less output. Profit is maximized.

Once the profit maximizing output is revealed, the last step is to identify the price charged by the monopoly. This is easily accomplished by clicking the [Price] button. Price is found by extending the 6-ounce quantity upward to the average revenue curve, which is the market demand. Buyers are willing to pay $7.50 per ounce for Amblathan-Plus if 6 ounces are sold.

Note that this $7.50 price is greater than the $4.50 marginal cost, which indicates that monopoly does not achieve the price-equals-marginal-cost condition for efficiency.

MONOPOLY, MARGINAL REVENUE AND DEMAND ELASTICITY:

The price elasticity of the demand curve facing a monopoly firm determines if the marginal revenue received by the monopoly is positive (elastic demand) or negative (inelastic demand). This relationship is important for the profit-maximizing production decision that involves equality between marginal revenue and marginal cost. It implies that a monopoly can only maximize profit in the elastic range of the demand curve.The relation between the price elasticity of demand and the marginal revenue curve indicates that a monopoly is only able to maximize profit by producing a quantity of output that falls in the elastic range of thedemand curve. A monopoly cannot maximize profit in the inelastic range of demand because this involves negative marginal revenue, and by virtue of the profit-maximizing equality between marginal revenue and marginal cost, it requires negative marginal cost, which is just not a realistic possibility.

The connection between marginal revenue and elasticity works like this:

If the demand is elastic, then marginal revenue is positive.

If the demand is inelastic, then marginal revenue is negative.

If demand is unit elastic, then marginal revenue is zero.

A Look at the CurvesTo see how this looks, consider the exhibit to the right, which depicts the revenue (total, average, and marginal) received by a well-known monopoly, Feet-First Pharmaceutical. Feet-First Pharmaceutical is the exclusive supplier of the

Revenue and Elasticity

hypothetical drug Amblathan-Plus, the only known treatment for the hypothetical foot ailment, amblathanitis.

The top panel in the exhibit presents a hump-shapedtotal revenue curve (TR). It is hump-shaped because Feet-First Pharmaceutical does not charge the same price for each quantity sold. As a monopoly, it must lower the price to sell more output.

The bottom panel then presents the average revenue curve (AR), which is also the market demand curve and the demand curve facing Feet-First Pharmaceutical, and themarginal revenue curve (MR), which indicates the extra revenue received for selling each extra ounce of Amblathan-Plus.

Now consider the price elasticity of the average revenue (demand) curve. A straight-line demand curve such as this one has different ranges of elasticity.

For relatively high prices and small quantities, the average revenue (demand) curve is relatively elastic.

For relatively low prices and large quantities, the average revenue (demand) curve is relatively inelastic.

The average revenue (demand) curve is unit elastic at the exact midpoint of the line, which in this case is 10.5 ounces of Amblathan-Plus.

Click the [Elasticity] button to reveal this information.

The key question is how these elasticity alternatives relate to marginal revenue and total revenue.

When the average revenue (demand) curve is elastic, marginal revenue is positive and total revenue is increasing.

When the average revenue (demand) curve is inelastic, marginal revenue is negative and total revenue is decreasing.

When average revenue (demand) curve is unit elastic, marginal revenue is zero and total revenue is not changing.

The primary conclusion is that marginal revenue is negative and total revenue is decreasing in the inelastic portion of the average revenue (demand) curve. For Feet-First Pharmaceutical to maximize profit in the inelastic range it needs negative marginal cost, which is just not realistic.

The Monopoly DreamTo see why this conclusion is so important, consider how it appears to contradict what would seem to be dream of any aspiring monopoly.

To achieve monopoly status, a firm must supply a good that has no close substitutes. Buyers must be forced to buy from the monopoly if they buy the good at all. However, the availability of substitutes is a key determinant of demand elasticity.

Elastic Demand: A good with many close substitutes tends to have an elastic demand. Because buyers are easily able to switch between substitutes, they are relatively sensitive to price changes.

Inelastic Demand: A good with very few close substitutes tends to have an inelastic demand. Because buyers are not able to switch between substitutes, they are not very sensitive to price changes.

The dream of any monopoly seller is to provide a good for which there are no alternatives. Such a good, however, tends to be relatively inelastic. And consequently marginal revenue is negative, which prevents profit maximization.

Are these aspiring monopolies misguided? Should they be searching for goods with elastic demand? Are they unaware of the relation between elasticity and marginal revenue? Do they not know that they can never maximize profit if they produce a good with inelastic demand?

A Profitable JourneyThe monopoly dream is not as misguided as it might first appear. The key is the phrase "profit maximization." Profit is MAXIMIZED when marginal revenue is positive and demand is elastic. In other words, when profit is maximized there is no way to INCREASE profit by doing something like increasing the price.

While profit maximization means profit can go no higher, the lack of profit maximization only means profit has NOT reached its peak. It does not mean profit is lacking. It does not mean that a monopoly firm is earning NO profit or incurring an economic loss. The lack of profit maximization ONLY means that the monopoly can take steps to increase profit. It can increase profit by doing something like increasing the price.

If a monopoly faces an inelastic demand curve, increasing the price is exactly what it can do. If the price of a good with inelastic demand is increased, then total revenue and profit also increase. Today the price is $1. Tomorrow the price is $2, and profit increases. The next day the price is $3, and profit increases again. When prices rise so too does profit. As long as demand is inelastic, then profit keeps rising. A "maximum" is not reached.

Is this is such a bad thing for the monopoly?

Not being AT THE MAXIMUM, but ONLY being able to increase profit is not really all that bad. Few firms would turn down the opportunity to be the sole provider of an inelastic product. Sure they might never MAXIMIZE their profit, that is, reach a nice stable equilibrium. But they can increase profit day after day, month after month, year after year, by raising prices. The "problem" is that profit can always go higher.

In the analysis of profit-maximization production, a monopoly NEVER selects an output level in the inelastic range of this demand curve. Feet-First Pharmaceutical NEVER willingly produces more than 10.5 ounces of Amblathan-Plus. Doing so requires that Feet-First Pharmaceutical operate with a quantity that generates negative marginal revenue.

If Feet-First Pharmaceutical found itself doing something like selling 15 ounces of Amblathan-Plus, then it undoubtedly raises the price, which reduces the quantity, which then increases total revenue, and which INCREASES profit. It continues this course until the quantity decreases enough to enter the elastic portion of the

demand curve. Only there is Feet-First Pharmaceutical be able to MAXIMIZE profit. However, up to that time, profit merely INCREASES. Not such a bad thing for the monopoly.

MONOPOLY, PROBLEMS:

Three problems often associated with a market controlled totally by a single firm are: (1) inefficiency, (2) inequity, (3) political abuse. While these problems are typically associated with a monopoly market structure, hence the title monopoly problems, they also relate to oligopoly and monopolistic competition to a lesser degree.Monopoly is a market structure containing a single firm that produces a unique good with no close substitutes. As such, monopoly is a price makerthat has complete control over the supply side of the market. And as the only firm in the market, the demand curve facing monopoly is the negatively-sloped market demand curve.

The result of monopoly's single-seller status and market control are three notable problems:

InefficiencyThe most noted monopoly problem is inefficiency. Market control means that a monopoly charges a higher price and produces less output than would be achieved under perfect competition. In addition, and most indicative of inefficiency, the price charged by the monopoly is greater than the marginal cost of production.

Monopoly produces the quantity of output that maximizes profit, like any other firm, by equating marginal revenue and marginal cost. However, because monopoly faces a negatively-sloped demand curve, price is greater than marginal revenue, meaning price is also greater than marginal cost and production is inefficient.

Income InequalityA lesser known problem with monopoly is an inequitable distribution of income. To the extent that monopoly earns economic profit, consumer surplus is transferred from buyers to the monopoly. Buyers end up with less income and the monopoly ends up with more. In addition, because price is greater than marginal cost and a monopoly receives economic profit, factor payments to some or all of the resources used by the monopoly are greater than their contributions to production. A portion of this economic profit is often "paid" to the owners of the labor, capital, or land, although not really "earned."

To the extent that monopoly is able to maintain single-seller status and market control, income continues to be transferred from buyers to the monopoly and to the monopoly resource owners. And to the extent the overall economy is comprised of monopoly sellers, this redistribution of income can be extensive.

Political AbuseA third potential problem, one tied directly to the concentration of income in the hands of the owners of monopoly resources, is the abuse of political power. The monopoly could use its economic profit to influence the political process, especially policies that might prevent potential competitors from entering the market.

A monopoly might be inclined to divert a portion of its economic profit to government officials and political decision makers to achieve "favorable" legislation and regulation, such as restrictions on competition from foreign companies. To the extent that monopoly is successful, the problems of inefficiency and inequity are perpetuated.

A Little GoodAlthough monopoly is the benchmark for an inefficient market structure, it is not necessarily all bad. There are a few redeeming virtues with monopoly. A monopoly might be inclined to use its economic profit to do good deeds, such as establishing charitable foundations, funding the fine arts, and supporting public education. A number of charitable foundations, theaters, museums, and universities carry the names of monopoly benefactors.

In addition, monopoly profits can be and have been used to invest in technological research and development, factory construction, and other capital goods that are intended to expand the profitability of the monopoly, but also promote economic growth economy-wide.

MONOPOLY PROFIT:

Economic profit generated as a result of a firm's market control. It is termed monopoly profit as a reflection of the most prominent market structure with market control--monopoly. However, any market structure with market control, including oligopoly and monopolistic competition, can generate monopoly profit. The existence of monopoly profit is an indication that a firm is NOT efficiently allocating resources. While market control in no way guarantees that a firm receives monopoly profit, there is no way to obtain monopoly profit WITHOUT market control.Monopoly profit arises when a firm with market control is able to set a price that exceeds average total cost. This is termed monopoly profit in honor of the monopoly market structure with the greatest market control and the one most likely to generate monopoly profit.

Market control enables a firm to acquire monopoly profit for two key reasons.

One, a firm that faces a negatively-sloped demand curve charges a higher price than a comparable perfectly competitive firm with no market control. The higher the price, the more likely it is to exceedaverage cost and thus to generate economic profit.

Two, barriers to entry are one source of market control, especially for monopoly. Such barriers prevent new firms from entering the market in response to above-normal economic profit. Economic or monopoly profit is not eaten away by competition.

Consider the production and sale of Amblathan-Plus, the only cure for the deadly (but hypothetical) foot ailment

Monopoly Profit

known as amblathanitis. This drug is produced by the noted monopoly firm, Feet-First Pharmaceutical.

A typical profit-maximizing output determination using the marginal revenue and marginal cost approach is presented in this exhibit. Feet-First Pharmaceutical maximizes profit by producing output that equates marginal revenue and marginal cost, which is 6 ounces of Amblathan-Plus in this example. The corresponding price charged is $7.50.

Because price is greater than average cost, Feet-First Pharmaceutical receives an economic profit, which by virtue of its monopoly market structure is monopoly profit. To highlight this profit, click the [Monopoly Profit] button.

The yellow rectangle, representing the difference between total cost andtotal revenue, is the monopoly profit received by Feet-First Pharmaceutical. This profit is determined in the following way:

First, the total revenue received by Feet-First Pharmaceutical is equal to the $7.50 price times the 6 ounces of Amblathan-Plus sold, which is $45 (= 6 x $7.50).

Second, the total cost incurred by Feet-First Pharmaceutical is equal to the $6.17 average total cost times the 6 ounces of Amblathan-Plus sold, which is $37 (= 6 x $6.17).

Third, monopoly profit is the difference between total revenue and total cost, which is $8 = ($45 - $37).

Not only is Feet-First Pharmaceutical more likely to generate such monopoly profit, but entry barriers (an exclusive patent on the production of Amblathan-Plus) prevents other firms from entering this market.

MONOPOLY, PROFIT ANALYSIS:

A monopoly produces the profit-maximizing quantity of output that generates the highest level of profit. This profit approach is one of three methods that used to determine the profit-maximizing quantity of output. The other two methods involve a comparison of total revenue and total cost or a comparison of marginal revenue and marginal cost.Monopoly is a market in which a single firm is the only supplier of the good. Anyone seeking to buy the good must buy from the monopoly seller. This single-seller status gives monopoly extensive market control--a price maker that faces a negatively-sloped demand curve. With this negatively-sloped demand curve, marginal revenue is less than average revenue and price.

Comparable to any profit-maximizing firm, a monopoly produces the quantity of output in the short run that generates the maximum difference between total revenue and total cost, which is economic profit. At this production level, the firm cannot increase profit by changing the level of production. The analysis of profit can be achieved through a table of numbers or by a comparison of total revenue and total cost curves.

Working the NumbersA monopoly is presumed to produce the quantity of output that maximizes economic profit--the difference between total revenue and total cost. This

decision can be analyzed using the exhibit below. This table presents revenue and cost information for Feet-First Pharmaceutical, a hypothetical example of a monopoly, for the production and sale of Amblathan-Plus, the only cure for the deadly (but hypothetical) foot ailment known as amblathanitis.

Because Feet-First Pharmaceutical produces a unique product it has extensive market control and sells its Amblathan-Plus according to the market demand. To sell a larger quantity, it must lower the price. Feet-First Pharmaceutical's status as a monopoly firm is reflected in this table.

Quantity: The quantity of output produced by the Feet-First Pharmaceutical, presented in the first column, ranges from 0 to 12 ounces of Amblathan-Plus. While, Feet-First Pharmaceutical could produce more than 12 ounces, this range is sufficient for the present analysis.

Price: The second column presents the price received by Feet-First Pharmaceutical for selling Amblathan-Plus. As a price maker, the first and second columns represent the market demand for Amblathan-Plus. The price Feet-First Pharmaceutical faces ranges from a high of $10.50 per ounce for a zero quantity to a low of $4.50 per ounce for 12 ounces. Feet-First Pharmaceutical can sell a larger quantity of Amblathan-Plus, but only by reducing the price. Feet-First Pharmaceutical is a price maker.

Total Revenue: Total revenue is presented in the third column. This indicates the revenue Feet-First Pharmaceutical receives at each level of Amblathan-Plus production. It is derived as the quantity in the first column multiplied by the price in the second column. Total revenue ranges from $0 if no output is sold to a high of $55 for selling 10 or 11 ounces of Amblathan-Plus. For example, selling 4 ounces of Amblathan-Plus generates $34 of revenue and selling 7 ounces leads to $49 of revenue.

Total Cost: The fourth column presents the total cost incurred by Feet-First Pharmaceutical in the production of Amblathan-Plus, ranging from a low of $10 for zero output (which is fixed cost) to a high of $117 for 12 ounces. Total cost continues to rise beyond 12 ounces, but this information is not needed. Producing 1 ounce of Amblathan-Plus incurs a total cost of $17. Producing 2 ounces of Amblathan-Plus incurs a total cost of $22. Total cost rises as Feet-First Pharmaceutical produces more.

Profit: The fifth column at the far right of the table is available to display economic profit, the difference between total revenue in the third column and total cost in the fourth column. A click of the [Profit] button displays Feet-First Pharmaceutical's economic profit in the fifth column.

The Numbers

The task is to determine the economic profit Feet-First Pharmaceutical earns for each quantity of Amblathan-Plus produced, then to identify which Amblathan-Plus production level provides the maximum profit.

A click of the [Incurring Losses] button indicates that producing and selling 1 ounce of Amblathan-Plus generates an economic loss of $7. Total revenue is $10 and total cost is $17. A $3 loss results from 2 ounces of Amblathan-Plus. Feet-First Pharmaceutical incurs an economic loss for the first 2 ounces of Amblathan-Plus. Feet-First Pharmaceutical also incurs an economic loss if production is 9 ounces or more.

But loss is not what Feet-First Pharmaceutical seeks. Click the [Earning Profits] button to highlight the range of production levels that generate positive economic profit. Feet-First Pharmaceutical initially turns its profit picture around with 3 ounces of Amblathan-Plus. At 3 ounces of Amblathan-Plus Feet-First Pharmaceutical's total revenue is greater than its total cost by $1. Profit remains positive through the production of 8 ounces of Amblathan-Plus, Feet-First Pharmaceutical's total revenue exceeds total cost and it receives an economic profit. For 5 ounces of Amblathan-Plus, this profit is $7, for 6 ounces profit is $8, and for 7 ounces profit drops back to $7 again.

So what is the profit-maximizing level of Amblathan-Plus production Feet-First Pharmaceutical should undertake? The desired production level is clearly not 2 ounces or less, nor is it 9 ounces or more, all of which lead to economic loss. It must be within the highlighted range between 3 and 8.

The quantity that generates the greatest of economic profit is 6 ounces of Amblathan-Plus. This alternative can be highlighted by clicking the [Profit Max] button. The production of 6 ounces of Amblathan-Plus results in $45 of total revenue and $37 of total cost, a difference of $8. No other production level generates a greater economic profit. Producing 1 more ounce of Amblathan-Plus or 1 less ounce of Amblathan-Plus reduces profit to $7.

Working the CurvesThe short-run production decision for a monopoly can be graphically illustrated by deriving a profit curve from the total revenue and total cost curves. The lower panel of the exhibit to the right is standing poised to display the profit curve for Amblathan-Plus production.

Total Revenue: The hump-shaped green line labeled TR depicts the total revenue that Feet-First Pharmaceutical receives from Amblathan-Plus production. The line is hump-shaped because Feet-First Pharmaceutical faces a negatively-sloped demand curve.

The Amblathan-Plus Curves

Total Cost: The curvy redline labeled TC represents the total cost that Feet-First Pharmaceutical incurs in the production of Amblathan-Plus. The shape is based on increasing, then decreasing marginal returns.

Profit: The vertical difference between these two lines is economic profit. If the total revenue line is above the total cost line in the middle of the diagram, economic profit is positive. If the total revenue line is below the total cost line at the far right and far left, economic profit is negative. The profit curve can be displayed in the lower panel by clicking the button labeled [Profit Curve].

Three segments of this profit curve are worth noting. First, profit is negative (that is, Feet-First Pharmaceutical incurs an

economic loss) for small quantities of output where the profit curve lies below the horizontal axis. Feet-First Pharmaceutical does not want to produce in this range.

Second, profit is positive for larger quantities of output where the profit curve rises above the horizontal axis. Feet-First Pharmaceutical wants to produce in this range.

Third, profit then becomes negative once again for the largest quantities of output where the profit curve dips below the horizontal axis again.

The key for Feet-First Pharmaceutical is to identify the production level that attains the peak of the profit curve. This is probably evident by looking at the exhibit, but it can be highlighted by clicking the [Profit Max] button. The output quantity identified is, once again, 6 ounces of Amblathan-Plus.

Before leaving this graph, two other quantities can be highlighted. The profit curve intersects the horizontal axis (meaning profit is zero) at two quantities--at just under 3 ounces of Amblathan-Plus and about 8.5 ounces of Amblathan-Plus. Click the [Breakeven] button to highlight these two output levels.

Both quantities are termed breakeven output. Breakeven output is a quantity of output in which the total revenue is equal to total cost such that a firm earns exactly a normal profit, and thus receives no economic profit nor incurs an economic loss. The reason for the term "breakeven" output is that the firm is just "breaking even." It is neither making a profit nor incurring a loss. Economic profit is zero. Breakeven output is usually most noteworthy as a reference point. The profit-maximizing production level invariably occurs between the two breakeven output levels.

ONOPOLY, PROFIT MAXIMIZATION:

A monopoly is presumed to produce the quantity of output that maximizes economic profit--the difference between total revenue and total cost. This production decision can be analyzed directly with economic profit, by identifying the greatest difference between total revenue and total cost, or by the equality between marginal revenue and marginal cost.

The profit-maximizing level of output is a production level that achieves the greatest level of economic profit given existing market conditions and production cost. For a monopoly, this entails adjusting the price and corresponding production level to achieved the desired match betweentotal revenue and total cost.

Three ViewsProfit-maximizing output can be identified in one of three ways--directly with economic profit, with a comparison of total revenue and total cost, and with comparison of marginal revenue and marginal cost.

This exhibit illustrates how it can be identified for a monopoly, such as that operated by Feet-First Pharmaceutical, a well-known monopoly supplier of Amblathan-Plus, the only cure for the deadly (but hypothetical) foot ailment known as amblathanitis. Feet-First Pharmaceutical is the exclusive producer of Amblathan-Plus, meaning that it is a price maker and the demand curve it faces is the market demand curve.

The top panel presents the profit curve. The middle panel presents total revenue and total cost curves. The bottom panel presents average revenueand average total cost curves. In all three panels, Feet-First Pharmaceutical maximizes when producing 6 ounces of Amblathan-Plus.

Profit: First, profit maximization can be illustrated with a direct evaluation of profit. If the profit curve is at its peak, then profit is maximized. In the top panel, the profit curve achieves its highest level at 6 ounces of Amblathan-Plus. At other output levels, profit is less.

Total Revenue and Total Cost: Second, profit maximization can be identified by a comparison of total revenue and total cost. The quantity of output that achieves the greatest difference of total revenue over total cost is profit maximization. In the middle panel, the vertical gap between the total revenue and total cost curves is the greatest at 6 ounces of Amblathan-Plus. For smaller or larger output levels, the gap is either less or the total cost curve lies above the total revenue curve.

Profit MaximizationProfit Curve

Total Curves

Marginal Curves

Marginal Revenue and Marginal Cost: Third, profit maximization can be identified by a comparison of marginal revenue and marginal cost. If marginal revenue is equal to marginal cost, then profit cannot be increased by changing the level of production. Increasing production adds more to cost than revenue, meaning profit declines. Decreasing production subtracts more from revenue than from cost, meaning profit also declines. In the bottom panel, the marginal revenue and marginal cost curves intersect at 6 ounces of Amblathan-Plus. At larger or smaller output levels, marginal cost exceeds marginal revenue or marginal revenue exceeds marginal cost.

More on the Marginal ViewFurther analysis of the marginal approach to analyzing profit maximization provides further insight into the short-run production decision of a monopoly.

First, consider the logic behind using marginals to identify profit maximization.

1. Marginal revenue indicates how much total revenue changes by producing one more or one less unit of output.

2. Marginal cost indicates how much total cost changes by producing one more or one less unit of output.

3. Profit increases if marginal revenue is greater than marginal cost and profit decreases if marginal revenue is less than marginal cost.

4. Profit neither increases nor decreases if marginal revenue is equal to marginal cost.

5. As such, the production level that equates marginal revenue and marginal cost is profit maximization.

With this in mind, now consider this exhibit to the right, which will eventually contain the marginal revenue and marginal cost curves for Feet-First Pharmaceutical's Amblathan-Plus production.

Average Revenue: First up is the average revenue curve, which can be seen with a click of the [Average Revenue] button. Because Feet-First Pharmaceutical is a monopoly, this average revenue curve is the market demand curve for Amblathan-Plus, which is negatively-sloped due to the law of demand.

Marginal Revenue: A click of the [Marginal Revenue] button reveals the greenline labeled MR that depicts the marginal revenue Feet-First Pharmaceutical receives from Amblathan-Plus production. Because Feet-

Profit Maximization,The Marginal View

First Pharmaceutical is a price maker, this marginal revenue curve is also a negatively-sloped line, and it lies beneath the average revenue (market demand) curve.

Marginal Cost: The marginal cost curve is U-shaped, reflecting the principles of short-run production. Click the [Marginal Cost] button to add this curve to the diagram. It has a negative slope for small amounts of output, then the slope is positive for larger quantities due to the law of diminishing marginal returns.

Profit Maximization: Profit is maximized at the quantity of output found at the intersection of the marginal revenue and marginal cost curves, which is 6 ounces of Amblathan-Plus. Click the [Profit Max] button to highlight this production level. This is the same profit-maximizing level identified using the total revenue and total cost curves and the profit curve.

Consider what results if marginal revenue is not equal to marginal cost:

If marginal revenue is greater than marginal cost, as is the case for small quantities of output, then the firm can increase profit by increasing production. Extra production adds more to revenue than to cost, so profit increases.

If marginal revenue is less than marginal cost, as is the case for large quantities of output, then the firm can increase profit by decreasing production. Reducing production reduces revenue less than it reduces cost, so profit increases.

If marginal revenue is equal to marginal cost, then the firm cannot increase profit by producing more or less output. Profit is maximized.

MONOPOLY, REALISM:

If taken to the extreme, monopoly, like perfect competition is an ideal market structure that does not actually exist in the real world. In the extreme, a "pure" monopoly is a market containing one and only ONE seller of good, a good with absolutely, positively no substitutes. The product is absolutely, certifiably unique. It not only has no CLOSE substitutes, it has NO substitutes. Period. End of story. In the real world, however, every product, no matter how unique it might appear to be, has substitutes. The substitutes might not be very close. They might be really, really bad substitutes. But they are substitutes. As such, there are no pure monopolies in the real world.Monopoly market structures can be thought of in one of two ways. One is as an abstract, theoretical model of a market containing a single seller. The other is as a realistic market in which one firm more or less dominates the market. The real world does not contain any theoretical, abstract "pure" monopoly markets. Neither does the real world contain other representations of idealized abstractions, such as a "dimensionless point" or a "utility-maximizing consumer."

However, in the real world, which contains every color EXCEPT absolute black and absolute white, there are also varying shades of monopoly. Real world monopolies are not "pure." They are NOT absolutely the ONLY firm in a market. They do NOT

produce a good that has absolutely NO substitutes. But some real world firms sort of, almost, kind of, come close to the theoretical ideal of monopoly.

Cable TelevisionConsider the provision of cable television as an example. Cable television providers are often given monopoly status by their local city governments. In other words, the company is the only one legally allowed to provide cable television to the residents of the town. Does cable television really fit the abstract, conceptual model of monopoly? Yes and no.

The key to monopoly rests with the number and closeness of available substitutes. Consider the hypothetical example 4M Cable Television Company operating in the hypothetical town of Shady Valley. While this example is hypothetical, it is representative of cable television services provided across the country.

While cable television is "unique," and if a company like 4M is given exclusive rights to provide cable television services it is considered a monopoly. But, substitutes DO exist. Network programming funneled through affiliates that broadcast through the airwaves offers a substitute for 4M's provision of cable television. Watching the Shady Valley Primadonnas baseball team play is a substitute. Viewing the exploits of Brace Brickhead at the Shady Valley Cineramaplex is a substitute. Reading a book, tending a garden, and even spending time clipping toenails are ALL substitutes for 4M cable television. None of these are perfect substitutes, none are great substitutes, but they ARE substitutes.

Public UtilitiesCable television shares many features of other services often referred to as public utilities. Public utilities provide electricity, natural gas, local telephone service, garbage collection, water distribution, and sewage disposal in virtually every city in the country. By and large, a single firm provides each utility service exclusively to a community--one electric company, one local telephone company, etc. Most of these are either government sanctioned monopolies or operated outright by the local government.

None of these are "pure" monopolies with absolutely, positively NO substitutes. But the available substitutes are NOT very close. Electricity is a substitute for natural gas, but they are not very close. The U.S. Postal Service (the mail) is a substitute for telephone, but it is not very close. Drilling a water well in the backyard is a substitute for city water distribution, but again, it is not quite the same. In fact, one reason public utilities are either government sanctioned monopolies or operated outright by the local government is that these products are unlike other goods.

PharmaceuticalsA growing category of monopoly markets falls in the pharmaceutical industry, the provision of drugs and other medications. In some cases, a firm develops a drug that is unlike anything previously available. The drug treats an ailment that has never before been treated. Many drugs, however, are improved methods of treating an ailment. The previous method might not be as effective, but it does represent a substitute.

When aspirin (salicylic acid) was first discovered, it represented a quantum improvement in health care, relieving headaches, reducing inflamed muscles, and curing other ailments. While substitutes were not close, they did exist. A cold

compress and a little rest might also cure a headache. Not quite the same as taking a couple of aspirin, but a remedy nonetheless.

Varying Degrees of SubstitutesWhile every good has some sort of substitutes available, some are close, other less so. Cake donuts and glazed donuts are close substitutes. Electricity and natural are not so close. Some substitutes are close enough to be considered as part of the same market. Other substitutes are different enough to be relegated to different markets. At some point, substitutes are so different that a good is considered "unique." If that good is supplied by a single firm, then a monopoly exists.

Is such a firm absolutely a monopoly? Probably not. Does it effectively operate like a monopoly? Probably so. If 4M Cable Television pays no heed to "substitutes" because customers are not inclined to switch from cable television to other goods in response to price changes, then 4M is a monopoly.

MONOPOLY, REVENUE DIVISION:

The marginal approach to analyzing a monopoly's profit maximizing production decision can be used to identify the division of total revenue among variable cost, fixed cost, and economic profit. The U-shaped cost curves used in this analysis provide all of the information needed on the cost side of the firm's decision. The demand curve facing the firm (which is also the firm's average revenue) and the corresponding marginal revenue curve provide all of the information needed on the revenue side.The total revenue received by a monopoly is divided among total fixed cost, total variable cost, and economic profit. This division can be illustrated using the marginal approach to analyzing the profit-maximization production decision.

The key to this division is to translate averages indicated by average curves into totals using the quantity produced. For example total revenue can be identified by multiplying average revenue by the quantity produced and total cost is obtained by multiplying average total cost by the quantity.

To see how revenue is divided, consider the production decision undertaken by Feet-First Pharmaceutical, a hypothetical monopoly that controls the production of Amblathan-Plus, the only cure for the deadly (but hypothetical) foot ailment known as amblathanitis. On the revenue side, Feet-First Pharmaceutical is a price maker with market control, meaning it faces a negatively-sloped demand curve.

On the cost side, Feet-First Pharmaceutical's short-run Amblathan-Plus production is guided by increasing, then decreasing marginal returns, which means that its cost is reflected by U-shaped cost curves.

The exhibit to the right sets the stage for identifying how the total revenue received by Feet-First Pharmaceutical from Amblathan-Plus production is divided. The profit-maximizing situation illustrated in this exhibit is

Revenue Division

based on the intersection of two curves--thegreen, negatively-sloped marginal revenue curve (MR), which is beneath the average revenue (demand) curve, and the U-shaped red marginal cost curve (MC). The intersection of these two curves at 6 ounces of Amblathan-Plus is the profit-maximizing production level. The price charged by Feet-First Pharmaceutical for this quantity is $7.50.

The task at hand is first to identify the total revenue Feet-First Pharmaceutical receives from producing Amblathan-Plus, then to identify the division of this revenue.

Total Revenue: Because Feet-First Pharmaceutical is a monopoly, the MR curve is negatively-sloped and below the average revenue curve. The price charged for 6 ounces is thus $7.50 per ounce. Total revenue is then simply the price ($7.50) times the quantity of output (6), which is $45.

Total revenue can be graphically highlighted as the rectangle bounded by the vertical and horizontal axes on the left and bottom, the $7.50 price on the top, and the vertical line at the quantity of 6 ounces connecting the MR-MC intersection point with the quantity axis on the right. Click the [Total Revenue] button to highlight this area.

Total Cost: The next task is to divide Feet-First Pharmaceutical's revenue between the total cost of production and its profit. Much like price times quantity generates total revenue, average total cost times quantity generates total cost. The average total cost of producing 6 ounces of Amblathan-Plus is $6.17 per ounce. This is found at the point where the vertical line designating the profit-maximizing 6 ounces of quantity intersects the ATC curve. Total cost is then average total cost ($6.17) times quantity (6), which is $37.

This total cost can be graphically highlighted as the rectangle bounded by the vertical and horizontal axes on the left and bottom, the horizontal line indicating $6.17 average total cost on the top, and the vertical line indicating 6 ounces of Amblathan-Plus on the right. Click the [Total Cost] button to illustrate this area.

Profit: The difference between the total revenue area and the total cost area is economic profit, equal to $8. This is the smaller rectangle near the top of the total revenue area. It is bounded on the left by the vertical price axis, on the top by the $7.50 price line, on the bottom by the horizontal line indicating $6.17 average total cost, and on the right by the vertical line indicating 6 profit-maximizing ounces of Amblathan-Plus production. Click the [Profit] button to highlight this area.

Total Variable Cost: Next up is the division of total cost between total variable cost and total fixed cost. The point at which the vertical line indicating 6 ounces of Amblathan-Plus intersects this AVC curve identifies average variable cost, which is $4.5 per ounce of Amblathan-Plus. Total variable cost is then average variable cost ($4.5) times quantity (6), which is $27. Total variable cost is the lower rectangular area bounded by the vertical and horizontal axes on the left and bottom, the line indicating average variable cost of $4.5 on the top, and the vertical line indicating 6 profit-maximizing ounces of Amblathan-Plus production on the right. Clicking the [Total Variable Cost] button highlights this area.

Total Fixed Cost: The last area to identify is total fixed cost. The portion of the total cost area not used for total variable cost goes for total fixed cost. The middle rectangle bounded on the left by the vertical price axis, on the top by the horizontal line indicating $6.17 average total cost, on the bottom by the horizontal line indicating $4.5 average variable cost, and on the right by the vertical line indicating 6 profit-maximizing ounces of Amblathan-Plus production is total fixed cost. Click the [Total Fixed Cost] to highlight this area.

MONOPOLY, SHORT-RUN PRODUCTION ANALYSIS:

A monopoly produces the profit-maximizing quantity of output that equates marginal revenue and marginal cost. This production level can be identified using total revenue and cost, marginal revenue and cost, or profit. Because a monopoly faces a negatively-sloped demand curve, it does not efficiently allocate resources by equating price and marginal cost.Monopoly is a market structure characterized by a single seller of a unique product that has no close substitutes. These conditions mean a monopoly has complete control of the supply side of the market, which also means that the negatively-sloped market demand curve is the demand curve facing the monopoly. With this demand curve, marginal revenue is less than both average revenue and price.

Comparable to any profit-maximizing firm, a monopoly produces the quantity of output in the short run that equates marginal revenue withmarginal cost. At this production level, the firm cannot increase profit by changing the level of production. Because price is not equal to marginal revenue, a monopoly does not produce the quantity of output that equates price and marginal cost, which means it is not efficiently allocating resources.

Determining OutputA monopoly is presumed to produce the quantity of output that maximizeseconomic profit--the difference between total revenue and total cost. This production decision can be analyzed in three different, but interrelated ways.

Profit: The first is directly through the analysis of economic profit, especially using a profit curve that traces the level of economic profit for different levels of output.

Total Revenue and Cost: A second is by comparing total revenue and total cost, commonly accomplished with total revenue and total cost curves.

Marginal Revenue and Cost: The third, and perhaps most noted, way is by comparing marginal revenue and marginal cost, similarly achieved with marginal revenue and marginal cost curves.

The profit-maximization production decision facing a monopoly can be analyzed using the exhibit below. This table presents revenue and cost information for Feet-First Pharmaceutical, a hypothetical example of a monopoly by virtue of its exclusive control over the supply of Amblathan-Plus, the only cure for the deadly (but hypothetical) foot ailment known as amblathanitis.

Quantity: The first column presents the quantity of output produced, ranging from 0 to 12 ounces of Amblathan-Plus.

Price: The second column presents the price received by Feet-First Pharmaceutical for selling Amblathan-Plus. As a price maker, the first and second columns represent the market demand for Amblathan-Plus. The price Feet-First Pharmaceutical faces ranges from a high of $10.50 per ounce for a zero quantity to a low of $4.50 per ounce for 12 ounces.

Total Revenue: The third column presents total revenue, ranging from a low of $0 for no output to a high of $55 for 10 and 11 ounces, before declining for 12 ounces.

Marginal Revenue: The fourth column presents marginal revenue, the change in total revenue due to a change in the quantity, which declines from a high of $10 to a low of -$1.

Total Cost: The fifth column presents the total cost incurred by Feet-First Pharmaceutical in the production of this Amblathan-Plus, ranging from a low of $10 for zero output (which is also fixed cost) to a high of $117 for 12 ounces of Amblathan-Plus.

Marginal Cost: The sixth column presents the marginal cost, the change in total cost due to a change in the quantity, which declines from $7, reaches a low of $3.50, then rises until reaching $25.

Profit: The seventh column at the far right of the table is profit, the difference between total revenue in the second column and total cost in the third column. It begins at -$11, rises to $8, then falls to -$63.

The choice facing Feet-First Pharmaceutical is to produce the quantity of Amblathan-Plus that maximizes profit. This can be easily identified using the far right "Profit" column. The quantity that generates the greatest level of economic profit is 6 ounces of Amblathan-Plus. This alternative can be highlighted by clicking the [Profit Max] button.

The production of 6 ounces of Amblathan-Plus results in $45 of total revenue and $37 of total cost, a difference of $8. No other production level generates a greater economic profit. Producing one more ounce of Amblathan-Plus or one less ounce of Amblathan-Plus reduces profit to $7. The price that achieves this profit-maximizing quantity is $7.50.

While marginal revenue and marginal cost might not appear to be equal for the profit-maximizing 6 ounces of Amblathan-Plus production ($5 versus $4), they really are. The reason is that the marginal numbers in the table actually represent

Profit Maximization,Monopoly Style

discrete changes from one ounce to the next. Reducing the size of the discrete change, say from 5.9999 ounces to 6 ounces, results in a marginal cost that is closer to $4.50. The same is true for marginal cost. At the limit of an infinitesimally small change, both marginal cost and marginal revenue are exactly $4.50.

Total CurvesThe short-run production decision for a monopoly can be graphically illustrated using total revenue and total cost curves, such as those displayed in the exhibit to the right. These total curves represent the total revenue and cost of Amblathan-Plus production by Feet-First Pharmaceutical the Amblathan-Plus grower.

Total Revenue: The hump-shaped green line (TR) depicts the total revenue Feet-First Pharmaceutical receives from Amblathan-Plus production. The line is hump-shaped because Feet-First Pharmaceutical must lower the price to sell a larger quantity.

Total Cost: The curvy red line (TC) depicts the total cost Feet-First Pharmaceutical incurs in the production of Amblathan-Plus. The shape is based on increasing, then decreasing marginal returns.

Profit: The vertical difference between these two lines is economic profit. If the total revenue line is above the total cost line in the middle of the diagram, economic profit is positive. If the total revenue line is below the total cost line at the far right and far left, economic profit is negative.

The key for Feet-First Pharmaceutical is to identify the production level that gives the greatest vertical distance between the total revenue and total cost curves in the middle of the diagram. This might not be evident by just looking at the exhibit, but it can be illustrated by clicking the [Profit Max] button. The output quantity identified is, once again, 6 ounces of Amblathan-Plus.

Marginal CurvesPerhaps the most common method of identifying the profit-maximizing level of production for a monopoly is using marginal revenue and marginal cost curves, such as those displayed in this exhibit.

Marginal Revenue: The negatively-sloped dark green line, labeled MR, is the marginal revenue Feet-First Pharmaceutical receives for each extra ounce of Amblathan-Plus sold.

Total Revenue and Cost

Marginal Revenue and Cost

Marginal Cost: The red U-shaped curve, labeled MC, is the marginal cost Feet-First Pharmaceutical incurs in the production of Amblathan-Plus. The shape is based on increasing, then decreasing marginal returns.

Average Revenue: The negatively-sloped light green line (AR) is the average revenue Feet-First Pharmaceutical receives from selling Amblathan-Plus, which is also the demand curve.

Average Cost: Two additional U-shaped curves included in the diagram (just for good measure) are average total cost (ATC) and average variable cost (AVC). These curves are helpful when identifying the level of economic profit or loss and the firm's short-run supply curve.

In this analysis, Feet-First Pharmaceutical needs to identify the quantity of output that achieves an equality between marginal revenue and marginal cost. This production can be highlighted by clicking the [Profit Max] button. The highlighted quantity is once again 6 ounces of Amblathan-Plus. The price charged by Feet-First Pharmaceutical to sell this quantity is $7.50.

Production AlternativesEven though monopoly is more likely to earn economic profit than a perfectly competitive firm, it is not guaranteed an economic profit. Should demand conditions change, monopoly might incur an economic loss or be forced to shut down in the short run. Comparable to any firm, a monopoly faces three short-run production alternatives based on a comparison of price, average total cost, and average variable cost.

P > ATC: Total revenue exceeds total cost and Feet-First Pharmaceutical receives a positive economic profit. In this case, Feet-First Pharmaceutical maximizes profit by producing the quantity of output that equates marginal revenue and marginal cost. More to the point, the price that Feet-First Pharmaceutical charges at the profit-maximizing quantity is greater than average total cost. This is the initial situation displayed in the graph.

ATC > P > AVC: Total revenue falls short of total cost, meaning Feet-First Pharmaceutical incurs an economic loss (or negative economic profit). This option can be displayed by clicking the [Less Demand] button. In spite of

Profit and Loss

the loss, because the price set at the profit-maximizing production level exceeds average variable cost, Feet-First Pharmaceutical can minimize loss by producing the indicated quantity of output. Feet-First Pharmaceutical receives enough revenue to cover ALL variable cost plus a portion of fixed cost. The loss from production is less than the loss from NOT producing, which is total fixed cost.

P < AVC: Total revenue also falls short of total cost, and Feet-First Pharmaceutical incurs an economic loss (or negative economic profit) that exceeds total fixed cost. This option can be displayed by clicking the [Even Less Demand] button. In this case Feet-First Pharmaceutical minimizes losses by reducing the quantity of output to zero, or producing no output in the short run. By producing a positive quantity, Feet-First Pharmaceutical does not receive enough revenue to cover variable cost, let alone any fixed cost. The economic loss from producing is greater than the economic loss of NOT producing, which is total fixed cost.

Short-Run Supply Curve?Market control means that monopoly does necessarily not have a supply relation between the quantity of output produced and the price. By way of comparison a perfectly competitive firm has a short-run supply curve based on the positively sloped marginal cost curve. A perfectly competitive firm's supply curve is that portion of the marginal cost curve that lies above the minimum of the average variable cost curve. A perfectly competitive firm maximizes profit by producing the quantity of output that equates price and marginal cost. As such, the firm moves along the marginal cost curve in response to alternative prices.

However, market control means that price is NOT equal to marginal revenue, and thus monopoly does NOT equate marginal cost and price. As such, a monopoly firm does not move along the marginal cost curve. A monopoly does not necessarily supply larger quantities at higher prices or smaller quantities at lower prices.

As a price maker that controls the market, a monopoly reacts to demand conditions, especially the price elasticity of demand, when setting the price and corresponding quantity produced. While it is not out of the question for a monopoly to supply a larger quantity at a higher price, it is also conceivable that a monopoly produces a smaller quantity at a higher price or a larger quantity at a lower price.

The bottom line is that monopoly does not necessarily have a short-run supply curve relation.

(In)EfficiencyBecause a monopoly charges a price that exceeds marginal cost, it does efficiently allocates resources. Price represents the value of goods produced and marginal cost represents the value of goods not produced. When both are equal, satisfaction cannot be increased by changing production.

(In)Efficiency

However, because price exceeds marginal cost, the economy gives up less satisfaction from other goods not produced than it receives from the good that is produced. The economy can gain satisfaction by producing more of the good.

This exhibit once again displays the profit-maximizing production output of Feet-First Pharmaceutical. Feet-First Pharmaceutical produces the quantity (6 ounces) of Amblathan-Plus that equates marginal revenue and marginal cost. The resulting price charge is $7.50 per ounce.

This price exceeds marginal cost, meaning Feet-First Pharmaceutical is inefficient. The price is higher and the quantity produced is less than what would be achieved with an efficient production.

To see why, consider how an efficient allocation would look. This alternative can be displayed with a click of the [Efficient] button. This efficient production level occurs at the intersection of the marginal cost curve (MC) and the demand/average revenue curve (AR). The efficient price is just under $7 per ounce and the efficient quantity produced is almost 7.5 ounces. At this production level, price is equal to marginal cost.

In comparison, the price charged by the monopoly is higher and the quantity produced is less.

MONOPOLY, SHORT-RUN SUPPLY CURVE:

Market control means that monopoly does not have a supply relation between the quantity of output produced and the price. In contrast, the short-run supply curve a perfectly competitive is that portion of its marginal cost curve that lies above the minimum of the average variable cost curve. However, because monopoly does not set price equal to marginal revenue, it does NOT equate marginal cost and price. For this reason, a monopoly firm does not respond to price changes by moving along its marginal cost curve. A monopoly does not necessarily supply larger quantities at higher prices or smaller quantities at lower prices.Monopoly maximizes profit by producing the quantity of output that equates marginal revenue and marginal cost. In that price (and average revenue) is greater than marginal revenue for a monopoly, price is also greater than marginal cost. Monopoly does not produce output by moving up and down along its marginal cost curve. The marginal cost curve is thus not the supply curve for monopoly.

As a price maker that controls the market, monopoly reacts to demand conditions, especially the price elasticity of demand, when setting the price and corresponding quantity produced. While it is not out of the question that monopoly offers a larger quantity for sale at a higher price, it is also conceivable that it offers a smaller quantity at a higher price or a larger quantity at a lower price.

Working a GraphConsider the production and sale of Amblathan-Plus, the only cure for the deadly (but hypothetical) foot ailment

Profit Maximization,The Marginal View

known as amblathanitis. This drug is produced by the noted monopoly firm, Feet-First Pharmaceutical.

A typical profit-maximizing output determination using the marginal revenue and marginal cost approach is presented in this diagram. Feet-First Pharmaceutical maximizes profit by producing output that equates marginal revenue and marginal cost, which is 6 ounces of Amblathan-Plus in this example. The corresponding price charged is $7.50.

What might happen, however, with a change in demand--in particular, a demand that leads to a higher price? For a perfectly competitive market, a higher price induces a larger quantity supplied as the market moves from one equilibrium to another, along a positively-sloped supply curve. The supply curve is positively sloped because it is comprised of positively-sloped marginal cost curves for every firm in the market.

Does this also happen for a monopoly? It might. But then again, it might not. Click the [Demand Shift] button to illustrate this shift. Note that the demand curve does not simply shift, slope (and elasticity) also change. This is the key.

Check out the new equilibrium. The monopoly seeks the production level that maximizes profit, just as it did before, by equating marginal revenue and marginal cost. This production level is 5 ounces, which is LESS than the original 6 ounce production level. The subsequent price charged by Feet-First Pharmaceutical is $9, obviously greater than the original $7.50 price.

Working DemandSo what has happened here?

The monopoly reacts to the changing price elasticity of demand. The new demand curve is less elastic. Buyers are less responsive to price changes. The monopoly takes advantage of this when setting the price and quantity that maximizes profit.

It not only raises the price, but the less elastic demand also makes it possible for the monopoly to reduce the quantity. The monopoly firm does not merely respond to the market price, as would happen for perfect competition, it "works the demand curve." Feet-First Pharmaceutical moves along the demand curve to find the best price-quantity combination available. And it can do this because it is a monopoly, with market control. It is a price maker.

Maybe a Supply Curve, Maybe NotThis analysis is not meant to imply that monopoly DOES NOT produce a larger quantity in response to higher price. It only indicates that it MIGHT NOT produce a larger quantity in response to higher price. However, the phrase "MIGHT NOT" is extremely important to the law of supply. Economic science pursues universal laws and economic principles that ALWAYS hold.

In particular, the key obstacle to the positive price-quantity supply relation is market control and the negatively-sloped demand curve facing the monopoly. As a matter of fact, any firm with market control, which includes all market structures EXCEPT perfect competition, has the same qualification about supply. And because perfect competition does not exist in the real world, all real world market structures have questionable supply curve relationships.

This is perhaps most important because implementing policies that are based on economic laws that may or may not hold can be troublesome. Given the realistic possibility that the law of supply does not hold, the application of market-based

policies can prove difficult, especially if the policies presume that firms react to higher price by increasing the quantity supply.

MONOPOLY, REVENUE DIVISION:

The marginal approach to analyzing a monopoly's profit maximizing production decision can be used to identify the division of total revenue among variable cost, fixed cost, and economic profit. The U-shaped cost curves used in this analysis provide all of the information needed on the cost side of the firm's decision. The demand curve facing the firm (which is also the firm's average revenue) and the corresponding marginal revenue curve provide all of the information needed on the revenue side.The total revenue received by a monopoly is divided among total fixed cost, total variable cost, and economic profit. This division can be illustrated using the marginal approach to analyzing the profit-maximization production decision.

The key to this division is to translate averages indicated by average curves into totals using the quantity produced. For example total revenue can be identified by multiplying average revenue by the quantity produced and total cost is obtained by multiplying average total cost by the quantity.

To see how revenue is divided, consider the production decision undertaken by Feet-First Pharmaceutical, a hypothetical monopoly that controls the production of Amblathan-Plus, the only cure for the deadly (but hypothetical) foot ailment known as amblathanitis. On the revenue side, Feet-First Pharmaceutical is a price maker with market control, meaning it faces a negatively-sloped demand curve.

On the cost side, Feet-First Pharmaceutical's short-run Amblathan-Plus production is guided by increasing, then decreasing marginal returns, which means that its cost is reflected by U-shaped cost curves.

The exhibit to the right sets the stage for identifying how the total revenue received by Feet-First Pharmaceutical from Amblathan-Plus production is divided. The profit-maximizing situation illustrated in this exhibit is based on the intersection of two curves--thegreen, negatively-sloped marginal revenue curve (MR), which is beneath the average revenue (demand) curve, and the U-shaped red marginal cost curve (MC). The intersection of these two curves at 6 ounces of Amblathan-Plus is the profit-maximizing production level. The price charged by Feet-First Pharmaceutical for this quantity is $7.50.

The task at hand is first to identify the total revenue Feet-First Pharmaceutical receives from producing Amblathan-Plus, then to identify the division of this revenue.

Total Revenue: Because Feet-First Pharmaceutical is a monopoly, the MR curve is negatively-sloped and below the average revenue curve. The price

Revenue Division

charged for 6 ounces is thus $7.50 per ounce. Total revenue is then simply the price ($7.50) times the quantity of output (6), which is $45.

Total revenue can be graphically highlighted as the rectangle bounded by the vertical and horizontal axes on the left and bottom, the $7.50 price on the top, and the vertical line at the quantity of 6 ounces connecting the MR-MC intersection point with the quantity axis on the right. Click the [Total Revenue] button to highlight this area.

Total Cost: The next task is to divide Feet-First Pharmaceutical's revenue between the total cost of production and its profit. Much like price times quantity generates total revenue, average total cost times quantity generates total cost. The average total cost of producing 6 ounces of Amblathan-Plus is $6.17 per ounce. This is found at the point where the vertical line designating the profit-maximizing 6 ounces of quantity intersects the ATC curve. Total cost is then average total cost ($6.17) times quantity (6), which is $37.

This total cost can be graphically highlighted as the rectangle bounded by the vertical and horizontal axes on the left and bottom, the horizontal line indicating $6.17 average total cost on the top, and the vertical line indicating 6 ounces of Amblathan-Plus on the right. Click the [Total Cost] button to illustrate this area.

Profit: The difference between the total revenue area and the total cost area is economic profit, equal to $8. This is the smaller rectangle near the top of the total revenue area. It is bounded on the left by the vertical price axis, on the top by the $7.50 price line, on the bottom by the horizontal line indicating $6.17 average total cost, and on the right by the vertical line indicating 6 profit-maximizing ounces of Amblathan-Plus production. Click the [Profit] button to highlight this area.

Total Variable Cost: Next up is the division of total cost between total variable cost and total fixed cost. The point at which the vertical line indicating 6 ounces of Amblathan-Plus intersects this AVC curve identifies average variable cost, which is $4.5 per ounce of Amblathan-Plus. Total variable cost is then average variable cost ($4.5) times quantity (6), which is $27. Total variable cost is the lower rectangular area bounded by the vertical and horizontal axes on the left and bottom, the line indicating average variable cost of $4.5 on the top, and the vertical line indicating 6 profit-maximizing ounces of Amblathan-Plus production on the right. Clicking the [Total Variable Cost] button highlights this area.

Total Fixed Cost: The last area to identify is total fixed cost. The portion of the total cost area not used for total variable cost goes for total fixed cost. The middle rectangle bounded on the left by the vertical price axis, on the top by the horizontal line indicating $6.17 average total cost, on the bottom by the horizontal line indicating $4.5 average variable cost, and on the right by the vertical line indicating 6 profit-maximizing ounces of Amblathan-Plus production is total fixed cost. Click the [Total Fixed Cost] to highlight this area.

BREAKEVEN OUTPUT:

The quantity of output in which the total revenue is equal to total cost such that a firm earns exactly a normal profit, but no economic profit. Breakeven output can be identified by the intersection of the total revenue and total cost curves, or by the intersection of the average total cost and average revenue curves. The most straightforward way of noting breakeven output, however, is with the profit curve. For a perfectly competitive firm breakeven output occurs where price is equal to average total cost.Breakeven output is a production level that achieves zero economicprofit. In other words, a firm is just "breaking even." The total revenuereceived by a firm at the breakeven output just matches the total cost incurred. However, because total cost includes anormal profit, only economic profitis zero. A firm generally reports a positive accounting profit at the breakeven level of production.

Breakeven output can be identified in one of three ways. This exhibit illustrates how breakeven output can be identified for a perfectly competitive firm, such as that operated by Phil the zucchini growing gardener. Phil sells zucchinis in a market with gadzillions of other zucchini growers and thus faces a going market price of $4 for each pound of zucchinis sold.

Comparable to any firm, whether perfectly competitive or one with greater market control, Phil encounters a breakeven output level if total revenue is equal to total cost, average revenue is equal to average total cost, and profit is zero.

In all three panels, Phil achieves breakeven output when producing about 3.5 pounds of zucchinis and when producing just over 9 pounds of zucchinis.

The top panel presents the profit curve. The middle panel presents total revenue and total cost curves. The bottom panel presents average revenue and average total cost curves.

Profit: First, breakeven output can be illustrated with a direct evaluation of profit. If profit is zero, then breakeven output is achieved. In the top panel, the profit curve intersects the horizontal axis, meaning economic profit is zero, at these two output levels. At other output levels profit is either positive or negative.

Breakeven OutputProfit Curve

Total Curves

Average Curves

Total Revenue and Total Cost: Second, breakeven output can be identified by a comparison of total revenue and total cost. If the two are equal, then profit is zero and breakeven output is achieved. In the middle panel, the total revenue and total cost curves intersect at both production levels. At relatively low or relatively high output levels, the total cost curve is above the total revenue curve and economic profit is negative. At output levels in the middle of the chart, economic profit is positive as the total revenue curve lies above the total cost curve.

Price and Average Cost: Third, breakeven output can be identified by a comparison of price (which is average revenue for a perfectly competitive firm) and average total cost. If per unit revenue is equal to per unit cost, then per unit profit is zero, overall profit is zero, and breakeven output is achieved. In the bottom panel, the average revenue and average total cost curves also intersect at both breakeven output levels. At relatively low or relatively high output levels, the average total cost curve is above the average revenue curve and economic profit is negative. At output levels in the middle of the graph, economic profit is positive as the average revenue curve lies above the average total cost curve.

While this discussion has been presented for a perfectly competitive firm, the story is essentially the same for firms operating in other market structures. The only difference is the shape and slope of the total revenue and average revenue curves. A monopoly, for example, faces a negatively-sloped demand curve. As such, the total revenue curve in the middle panel is a "hump-shaped" curve rather than a straight line and the average revenue curve in the bottom panel is negatively sloped.

However, the breakeven points are identified in the same manner. They occur at the intersections of the total revenue and total cost curves and the intersections of the average revenue and average total cost curves.

MONOPOLY, SHUTDOWN:

A monopoly is presumed to produce the quantity of output that minimizes economic loss, if price is greater than average variable cost but less than average total cost. This is one of three short-run production alternatives facing a firm. The other two are profit maximization (if price exceeds average total cost) and loss minimization (if price is greater than average variable cost but less than average total cost).A monopoly guided by the pursuit of profit is inclined to produce no output if the quantity that equates marginal revenue and marginal cost in the short run incurs an economic loss greater than total fixed cost. The key to this shutdown production decision is a comparison of the loss incurred from producing with the loss incurred from not producing. If price is less thanaverage variable cost, then the firm incurs a smaller loss by not producing than by producing.

One of Three AlternativesShutting down is one of threeshort-run productionalternatives facing a monopoly. All three are displayed in the table to the right. The other two areprofit maximization and loss minimization.

Production Alternatives

Price and Cost Result

P > ATC Profit Maximization

ATC > P > AVC Loss Minimization

P < AVC Shutdown

With profit maximization, price exceeds average total cost at the quantity that equates marginal revenue and marginal cost. In this case, the firm generates an economic profit.

With loss minimization, price exceeds average variable cost but is less than average total cost at the quantity that equates marginal revenue and marginal cost. In this case, the firm incurs a smaller loss by producing some output than by not producing any output.

Amblathan-Plus ProductionThe marginal approach to analyzing a monopoly's short-run production decision can be used to identify the economic loss alternative. The exhibit displayed here illustrates the short-run production decision by Feet-First Pharmaceutical, the monopoly producer of Amblathan-Plus, the only cure for the deadly (but hypothetical) foot ailment known as amblathanitis.

The three U-shaped cost curves used in this analysis provide all of the information needed on the cost side of the firm's decision. The demand curve facing the firm (which is also the firm's average revenue curves) and the corresponding marginal revenue curve provide all of the information needed on the revenue side.

For the time being, Feet-First Pharmaceutical maximizes profit by producing 6 ounces of Amblathan-Plus and charges a price of $7.50. This profit-maximizing situation depends on the existing market demand conditions. However, should this demand change, then maximizing a positive profit is not the primary concern of Feet-First Pharmaceutical. Its decision turns to minimizing loss. Click the [Less Demand] button to illustrate the situation facing Feet-First Pharmaceutical with a decrease in demand.

As the demand shifts leftward, the marginal revenue curve also shifts leftward. The new profit-maximizing intersection between marginal cost and marginal revenue is at 2 ounces of Amblathan-Plus. The price Feet-First Pharmaceutical charges for this quantity of production is then $5.50.

The key is that this new, lower price is less than average variable cost. This means that Feet-First Pharmaceutical does not generate enough revenue per ounce of Amblathan-Plus sold (average revenue = $5.50) to cover the variable cost of producing each ounce of Amblathan-Plus (average variable cost = $6), let alone total cost (average total cost = $11).

Profit and Loss

Feet-First Pharmaceutical clearly incurs an economic loss on each ounce of Amblathan-Plus produced and sold. In fact, if Feet-First Pharmaceutical produces 2 ounces of Amblathan-Plus, then its total cost is $22, but its total revenue is only $11. It incurs an economic loss of $11, a loss of $5.50 per ounce produced.

The Short-Run ChoicePerhaps Feet-First Pharmaceutical should stop producing. Perhaps it would be better off by NOT selling Amblathan-Plus. Unfortunately, Feet-First Pharmaceutical is faced with short-run fixed cost. Feet-First Pharmaceutical incurs a total fixed cost of $10 whether or not it engages in any short-run production. Even if it shuts down production, it still must pay this $10 of fixed cost.

As such, Feet-First Pharmaceutical is faced with a comparison between the loss incurred from producing with the loss incurred from not producing. Those are its two short-run choices. If it produces, it incurs a loss of $11. If it does not produce, it incurs a loss of $10.

The choice seems relatively obvious: Feet-First Pharmaceutical is better off not producing any Amblathan-Plus, incurring an economic loss of $10, and hoping for an increase in the demand. Should it produce any Amblathan-Plus, it incurs a greater loss than just paying total fixed cost.

Feet-First Pharmaceutical does not produce in the short run because it does not generate enough revenue to pay its variable cost, let alone any part of fixed cost. By producing 2 ounces of Amblathan-Plus, it generates $11 of total revenue. This revenue not only falls short of covering the $22 of total cost, neither is it enough to pay the $12 of total variable cost. This is why the economic loss from production is greater than total fixed cost.

Even though Feet-First Pharmaceutical has complete control of the supply-side of the market, it is still subject to the whims of the demand-side of the market. This $5.50 Amblathan-Plus price does not generate sufficient total revenue for Feet-First Pharmaceutical to pay ALL variable cost, let alone fixed cost. However, should demand change, then Feet-First Pharmaceutical would have to reevaluate its production decision. If the demand increases enough, Feet-First Pharmaceutical will be able to produce Amblathan-Plus in the short run.

MONOPOLY, SOURCES:

Monopolies achieve their single-seller status for three interrelated reasons: (1) economies of scale, (2) government decree, and (3) resource ownership. While a monopoly can emerge and persist for any one of these reasons, most monopolies rely on more than one and often all three.Monopoly is a market in which a single firm is the only supplier of the good. Anyone seeking to buy the good must buy from the monopoly seller. This single-seller status gives monopoly extensive market control. It is a price maker. The market demand for the good sold by a monopoly is the demand facing the monopoly.

A monopoly market structure emerges and continues to exist for three primary reasons. One is by taking advantage of economies of scale and decreasing average cost over the range of market demand. A second is through authorization that legally designates a single firm as the exclusive provider of a good. The third is through complete ownership of a resource or input that is essential to the production of a good.

Consider these three sources of monopoly market control.

Economies of ScaleMany real world monopolies emerge due to economies of scale and decreasing average cost. If average cost decreases over the entire range of demand, then a single seller can provide the good at lower per unit cost and more efficiently than multiple sellers. This often leads to what is termed a natural monopoly. The market might start with more than one seller, but it naturally ends up with a single seller that can best take advantage of decreasing average cost. Many public utilities (such as electricity distribution, natural gas distribution, garbage collection) have this natural monopoly inclination.

A monopoly naturally emerges in a market that experiences decreasing average cost. Suppose, for example, that two firms (4M and Clear Cable) provide cable television services to the local Shady Valley television market. Each firm has a vast network of underground cables, converter boxes, computers, satellite receivers, and other capital equipment. With this capital, average cost declines as the relative high fixed cost is spread over more subscribers.

If each firm has half of the market, then each has equal average cost and can charge comparable prices. However, what happens if 4M obtains a few additional customers? With lower average cost, 4M can profitably charge a lower price than Clear Cable. This is bound to induce some Clear Cable subscribers to switch. As 4M provides cable services to an increasing number of subscribers, its average cost and prices decline. And as Clear Cable loses subscribers, its average cost and price rise. Clear Cable is increasingly at a competitive disadvantage. It is forced to charge higher and higher prices and 4M charges lower and lower prices.

An avalanche of subscribers flock to 4M, forcing Clear Cable out of business. The end result, naturally, is a single seller of cable television--a monopoly.

Government DecreeThe monopoly status of firm can be established by the mandate ofgovernment. Government simply gives one and only one firm the legal authority to supply a particular good. Such single seller legal status is usually justified on economic grounds, such as an electric company that would naturally tend to monopolize a market. However, it might also result from political forces, such as mandating monopoly status to a firm controlled by a campaign donor or close political associate.

Government often extends monopoly control to a single firm in markets characterized by decreasing average cost. Such government authority, however, is usually accompanied by government regulation. Because a monopoly market tends to be inefficient, government often steps into those markets that naturally tend toward monopoly, preemptively establishing the monopoly, then regulating the firm to address any inefficiency that might occur.

Government effectively says, "You can be a monopoly, but you must play by our rules."

Of course, government has the power to create monopoly where none would exist otherwise. Government patents provide an example. In the world of pharmaceuticals, government patents establish monopoly in the markets for assorted drugs. Although dozens of firms could, in principle, provide the same drug, government often restricts the market to a single firm.

This is generally done to encourage pharmaceutical firms to invest time and money in the research and development of new drugs. The exclusive patent allows the firm to recoup this investment. For example, in the hypothetical world

of Feet-First Pharmaceutical, their patent on the drug Amblathan-Plus used to cure the deadly foot ailment known as amblathanitis, generates oodles of revenue and profit. However, this is a reward for the years of research and millions of dollars of investment spent developing the drug. Had they lacked the expectations of such reward, then they probably would not have undertaken the investment, and society's health would have suffered.

Resource OwnershipA monopoly is likely to arise if a firm has complete control over a key input or resource used in production. If the firm controls the input, then it controls the output. Monopolies have arisen over the years due to control over material resources (petroleum and bauxite ore), labor resources (talented entertainers and skilled athletes), or information resources (patents and copyrights).

Resource ownership is often a key source of monopoly control. The firm that controls the resource input is able to control the good produced. Because mineral deposits and fossil fuels tend to be geographically concentrated, they often emerge as monopoly-enabling resources. The petroleum market, in particular, has been perpetually prone toward monopoly from J. D. Rockefeller and the Standard Oil Trust in the late 1800s to the Organization of Petroleum Exporting Countries in more recent times.

Labor is another resource that is amenable to monopoly. The labor unionmovement of the late 1800s and early 1900s was designed to monopolize the supply of labor for a given industry or skill. Professional entertainers and athletes, to the extent that they possess unique talents and abilities, are also prone toward monopoly.

p r i c e a n d o u t p u t u n d e r a p u r e m o n o p o l y

THE MONOPOLISTS DEMAND CURVE- CONSTRAINTS ON MONOPOLY

Be careful of saying that "monopolies can charge any price they like" - this is wrong. It is true that a firm with monopoly has price-setting power and will look to earn high levels of profit. However the firm is constrained by the position of its demand curve. Ultimately a monopoly cannot charge a price that the consumers in the market will not bear.

A pure monopolist is the sole supplier in an industry and, as a result, the monopolist can take the market demand curve as its own demand curve. A monopolist therefore faces a downward sloping AR curve with a MR curve with twice the gradient of AR. The firm is a price maker and has some power over the setting of price or output. It cannot, however, charge a price that the consumers in the market will not bear. In this sense, the position and the elasticity of the demand curve acts as a constraint on the pricing behaviour of the monopolist. Assuming that the firm aims to maximise profits (where MR=MC) we establish a short run equilibrium as shown in the diagram below.

 Assuming that the firm aims to maximise profits (where MR=MC) we establish a short run equilibrium as shown in the diagram below.

The profit-maximising output can be sold at price P1 above the average cost AC at output Q1. The firm is making abnormal "monopoly" profits (or economic profits) shown by the yellow shaded area. The area beneath ATC1 shows the total cost of producing output Qm. Total costs equals average total cost multiplied by the output.

A CHANGE IN DEMAND

A change in demand will cause a change in price, output and profits.

In the example below, there is an increase in the market demand for the monopoly supplier. The demand curve shifts out from AR1 to AR2 causing a parallel outward shift in the monopolist's marginal revenue curve (MR1 shifts to MR2). We assume that the firm continues to operate with the same cost curves. At the new profit maximising equilibrium the firm increases production and raises price.

Total monopoly profits have increased. The gain in profits compared to the original price and output is shown by the light blue shaded area.

Not all monopolies are guaranteed profits - there can be occasions when the costs of production are greater than the average revenue a monopolist can charge for their products. This might occur for example when there is a sharp fall in market demand (leading to an inward shift in the average revenue curve). In the diagram below notice that ATC lies AR across the entire range of output. The monopolist will still choose an output where MR=MC for this reduces their losses to the minimum amount.

How do monopolies continue to earn supernormal profits in the long run - revise barriers to entry. See also the pages on price discrimination

Mobile Phone Operators and Supernormal Profits

In the first of its mobile market reviews, OFTEL, the telecommunications industry regulators has found that mobile phone operators are making profits greater than would be expected in a fully competitive market. Their research finds that mobile phone charges have fallen by nearly a quarter since January 1999. And, the level

of consumer satisfaction with their mobile phone service continues to run high (at around 90%).

But the OFTEL review finds that consumers do not have sufficient information on the range of prices available from the mobile phone networks and they are being over-charged for calls between mobile networks. OFTEL have stated that some sectors of the industry may require more intensive regulation unless there are improvements in pricing in the coming months.