4.2 Profit maximization under monopoly

Monopoly power lets companies set prices and control output. This section dives into how monopolists maximize profits by finding where marginal revenue equals marginal cost, leading to higher prices and less production than in competitive markets.

Understanding monopoly pricing is key to grasping market inefficiencies. We'll look at how monopolists use demand curves and elasticity to make decisions, and compare monopoly outcomes to perfect competition to see why regulators often step in.

Profit Maximization for Monopolists

Monopoly Market Power and Profit Maximization

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• Monopolists operate as sole suppliers in markets granting significant power to influence price and output
• Profit-maximizing condition occurs where marginal revenue (MR) equals marginal cost (MC)
• Downward-sloping demand curve causes monopolist's price to exceed marginal revenue
• Profit-maximizing price determined by demand curve point above MR = MC intersection
• Barriers to entry allow monopolists to earn economic profits in short and long run
• Monopolist output typically falls below socially optimal level leading to deadweight loss
• Profit-maximizing output found by equating MR and MC $(MR = MC)$

Monopoly Pricing and Output Decisions

• Monopolists set prices higher and produce less compared to perfect competition
• Price determined by corresponding point on demand curve where MR = MC
• Economic profits persist in long run due to lack of competition
• Allocative inefficiency arises from pricing above marginal cost $(P > MC)$
• Productive inefficiency occurs by not producing at minimum average total cost
• Deadweight loss represents economic inefficiency compared to perfect competition
• Examples of monopoly markets (utilities, patented pharmaceuticals)

Marginal Revenue for Monopolists

Marginal Revenue Curve Characteristics

• Monopolist's marginal revenue curve always below demand curve except at y-intercept
• For linear demand, MR curve has twice the slope and same y-intercept as demand curve
• Total revenue (TR) and marginal revenue (MR) relationship crucial for analysis
• MR decreases faster than price as output increases
• MR becomes negative at TR maximum point
• Understanding MR curve essential for determining profit-maximizing output $(MR = MC)$
• Examples of MR curves (linear, non-linear)

Marginal Revenue and Pricing Strategy

• Increasing output requires lowering price for all units sold, not just additional units
• Price reduction on all units causes MR to decrease faster than demand curve
• MR curve helps identify optimal pricing and output decisions
• Monopolists always operate where MR is positive to maximize profits
• Relationship between MR and demand elasticity influences pricing decisions
• Examples of how changes in demand affect MR curve (shifts, rotations)

Monopolist vs Perfect Competition

Market Structure Comparison

• Monopoly equilibrium price higher and quantity lower than perfect competition
• Monopolists produce where MR = MC, perfect competition where P = MC = MR
• Long-run economic profits for monopolists vs normal profits in perfect competition
• Consumer surplus partially transferred to producer surplus under monopoly
• Allocative inefficiency in monopoly $(P > MC)$ vs efficiency in perfect competition
• Productive inefficiency in monopoly vs efficiency in perfect competition
• Examples of industries transitioning from monopoly to competition (telecommunications, airlines)

Welfare Effects and Efficiency

• Deadweight loss represents economic inefficiency of monopoly compared to perfect competition
• Consumer surplus reduced and producer surplus increased under monopoly
• Total welfare lower in monopoly due to output restriction
• Potential for X-inefficiency in monopolies due to lack of competitive pressure
• Regulatory interventions aim to reduce monopoly inefficiencies (price ceilings, antitrust policies)
• Innovation incentives may differ between monopoly and competitive markets
• Examples of welfare effects in specific monopolized industries (prescription drugs, software)

Elasticity and Monopolist Pricing

Price Elasticity and Profit Maximization

• Price elasticity of demand crucial for monopolist's pricing strategy and profit maximization
• Monopolists always operate in elastic portion of demand curve where |Ed| > 1
• Lerner Index $(L = (P - MC) / P)$ measures market power, inversely related to demand elasticity
• More inelastic demand allows higher markup over marginal cost, increasing profit margin
• Elasticity varies along a linear demand curve, influencing optimal pricing decisions
• Examples of how elasticity affects monopoly pricing (luxury goods, necessities)

Price Discrimination Strategies

• Price discrimination based on differences in demand elasticity among consumer groups
• Market segmentation allows charging different prices to maximize total profit
• First-degree (perfect) price discrimination extracts all consumer surplus
• Second-degree price discrimination uses quantity discounts or quality variations
• Third-degree price discrimination charges different prices to distinct market segments
• Elasticity differences between markets determine optimal price discrimination strategy
• Examples of price discrimination (airline tickets, student discounts, regional pricing)