Maximizing Profit under Monopoly

… a core concept in Economic Analysis and Atlas102

Concept description

Alex Tabarrok (reference below, video on right) addresses maximizing profit under Monopoly.

Tabarrok notes that firms can acquire Market Power by selling a unique good with Barriers to Entry, such as:

• Patents
• Government regulations other than patents
• Economies of Scale
• Exclusive access to an important input
• Technological Innovation

He then shows how the monopolist will set both price and output to maximize profit.

For a linear demand curve one can use a short cut for finding the marginal revenue: the MR begins at the same point on the vertical axis as the demand curve and has twice the slope, and splits the distance on the horizontal axis in half.

And, using the example of a pharmaceutical firm with the monopoly on an AIDS antiviral drug, Tabarrok shows how to add the average cost curve and calculate the monopolist’s profit.

Practice questions

From http://www.mruniversity.com/node/267321, accessed 7 May 2016.

1. In the textbook, The Applied Theory of Price, D. N. McCloskey refers to the equation MR= MC as the rule of rational life. Who follows this rule: monopolies, competitive firms, both or neither?
   1. Monopolies
   2. Competitive firms
   3. Both 
   4. Neither
2. Rapido, the shoe company, is so popular that it has monopoly power. It’s selling 20 million shoes per year. The marginal cost of making extra shoes is quite low, and it doesn’t change much if they produce more shoes. Rapido’s marketing experts tell the CEO of Rapido that if it decreased prices by 20%, it would sell so many more shoes that profits would rise. If the expert is correct, at its current output, is MC=MR, is MC >MR, or is MC < MR?
   1. MC=MR
   2. MC greater than MR
   3. MC less than MR
3. If the expert is correct and Rapido’s CEO follows the experts’ advice, will Rapido’s total revenue rise, fall, or be unchanged? 
   1. Total revenue will rise
   2. Total revenue will fall
   3. Total revenue will remain unchanged
4. Apollo, another highly profitable shoe company, also has market power. It’s selling 15 million shoes per year, and it faces marginal costs quite similar to Rapido. Apollo’s marketing experts conclude that if they increased prices by 20%, profits would rise. For Apollo, is MC=MR, is MC greater than MR, or is MC less than MR?
   1. MC=MR
   2. MC greater than MR
   3. MC less than MR
5. When selling e-books, music on iTunes, and downloadable software, the marginal cost of producing and selling one more unit of output is essentially zero: MC = 0. Let’s think about a monopoly in this kind of market. If the monopolist is doing its best to maximize profits, what will marginal revenue equal at a firm like this?
   1. Greater than 0
   2. Less than 0 
   3. 0 
   4. Indeterminate from the given information
6. All firms are trying to maximize their profits (profit = TR – TC). The rule from the previous question tells us that in the special case where marginal cost is zero, “profit maximization” is equivalent to which of the following statements?
   1. “Maximize total revenue”
   2. “Minimize total cost” 
   3. “Minimize average cost” 
   4. “Maximize average revenue”
7. Which of the following is true when a monopoly is producing the profit-maximizing quantity of output? More than one may be true. 
   1. Marginal revenue = Average cost
   2. Total cost = Total revenue
   3. Monopoly Price = Marginal cost
   4. Marginal revenue = Marginal cost
   5. A & C 
   6. C & D
8. For the following statements, decide whether it is true or false. When a monopoly is maximizing its profits, price is greater than marginal cost.
   1. True 
   2. False
9. For a monopoly producing a certain amount of output, price is less than marginal revenue. 
   1. True 
   2. False

Atlas topic, subject, and course

Monopoly and Price Discrimination (core topic) in Economic Analysis and Atlas102 Economic Analysis.

Source

Alex Tabarrok, Maximizing Profit under Monopoly (11-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/monopoly-profit-maximization-price-aids-medication, accessed 7 May 2016.

Page created by: Ian Clark, last modified 7 May 2016.

Image: Alex Tabarrok, minute 0.14 of Maximizing Profit under Monopoly (11-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/monopoly-profit-maximization-price-aids-medication, accessed 7 May 2016.