A monopoly firm will produce at the level of output which maximizes the monopolist’s profit. In order to maximize profit, it produces at the level of output where marginal cost is equal to marginal revenue. Since the monopoly is the only firm producing a certain product, the monopolist is the industry, so the monopolist’s demand curve is the industry’s demand curve and is downwards sloping. Because the demand curve is downwards sloping, there is an inverse relationship between quantity demanded and price. This means that the monopolist can either control the price or the level of output, but not both. It would seem that a monopolist would have total control over both price and level of output, but in order to sell more they must lower their price. The monopolist’s marginal revenue curve is below the demand curve, so in order for the monopoly firm to maximize its profit, the level of output at which the monopolist is producing is where marginal cost equals marginal revenue. Furthermore, if the monopolist has experienced economies of scale and have an average cost curve that is below the demand curve, it is possible for the monopolist to be making abnormal profits.
2) Using a diagram, explain the concept of a natural monopoly.
An industry is a natural monopoly if there are only enough economies of scale available in the market to support one firm. Examples of natural monopolies include the industries that supply utilities such as water, electricity, and gas. If the monopolist, which is the industry, has the demand curve D1 and its long run average costs are lower than its average revenue for the level of output that the monopolist is producing at, then it is able to earn abnormal profits. The shape and position of the long run average costs curve depends on the economies of scale experienced by the monopolist. If another firm would enter the industry, then the quantity demanded would be shared between the two firms, causing the industry’s demand curve to shift to the left. This causes the long run average costs curve to be positioned above the demand curve, so the firm’s average costs are greater than the firm’s average revenue. For this reason, both firms in the industry would stop earning abnormal profits, and they would not even be able to earn normal profits. The monopolist will only be able to earn abnormal profits again if it manages to produce at the level of output that is demanded in the market. The only way it could do that, though, is by lowering the long run average costs so that it is below the average revenue of the monopolist. However, that would be impossible because the economies of scale are limited so the market can only support one firm.3) Using appropriate diagrams, explain whether a monopoly is likely to be more efficient or less efficient than a firm in perfect competition.
A monopoly is likely to be less efficient than a firm in perfect competition. Unlike perfect competition, the monopolist produces at the profit maximizing level of output, where there is neither productive efficiency nor allocative efficiency. A monopolist acts in its own interest, while perfect competition takes into account the needs of the consumers. In a monopoly, output is restricted in order to increase the price and to earn the maximum amount of profit. A firm is productively efficient if it produces at the point where average cost equals marginal cost and it is allocatively efficient if it produces at the point where marginal cost is equal to average revenue. However, the monopolist is producing at the level of output where marginal cost is equal to marginal revenue, which explains why it is neither productively nor allocatively efficient. In a perfectly competitive market, the firm produces an optimal mix of goods and services that are demanded by consumers. The competition between firms causes an increase in price to always be competed back down to the equilibrium price, so a firm in perfect competition is always efficient, since their price cannot be forced up because the demand is perfectly elastic, so consumers could easily switch to buying their products from a firm whose price is lower. A monopolist, however, is forced to have higher prices and lower output, so it does not have to be efficient to earn profit.
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