A monopoly firm faces a typical downward-sloping demand (D) curve, a corresponding downward-sloping marginal revenue (MR) curve below the demand curve, and an upward-sloping marginal cost (MC) curve. It currently produces at an output level of 100,000 units, where marginal revenue (MR) is $25, and marginal cost (MC) is $40. (a) (i) Write the profit-maximising rule for determining the level of output and price charged by the monopolist. (3 marks) (ii) Explain the economic reasoning for this profit maximisation rule, and evaluate which market structures this rule applied to, and why.
Question
A monopoly firm faces a typical downward-sloping demand (D) curve, a corresponding downward-sloping marginal revenue (MR) curve below the demand curve, and an upward-sloping marginal cost (MC) curve. It currently produces at an output level of 100,000 units, where marginal revenue (MR) is 40. (a) (i) Write the profit-maximising rule for determining the level of output and price charged by the monopolist. (3 marks) (ii) Explain the economic reasoning for this profit maximisation rule, and evaluate which market structures this rule applied to, and why.
Solution
(a) (i) The profit-maximising rule for a monopolist is to produce at a level where Marginal Revenue (MR) equals Marginal Cost (MC). In other words, MR = MC.
(ii) The economic reasoning behind this rule is that profit is maximised when the cost of producing an additional unit (MC) is exactly equal to the revenue gained from selling that additional unit (MR). If MR is greater than MC, the firm can increase profit by producing more. If MC is greater than MR, the firm can increase profit by producing less.
This rule applies to all market structures, not just monopoly. In perfect competition, firms are price takers and can sell as much as they want at the market price, so they produce where price equals MC. In monopolistic competition and oligopoly, firms have some market power and face downward-sloping demand curves, so they also produce where MR equals MC. However, the rule is most associated with monopoly because monopolists have the most market power and their decision about how much to produce can significantly affect the market price.
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