Monopoly Questions P. 112

1. Explain the level of output at which a monopoly firm will produce.

Like any firm in any market, a monopoly will try to maximize profits. The monopolist’s demand curve is the industry demand curve as the monopolist is the industry, meaning it is downward sloping. Because the firm is the industry, it can change either the quantity produced or the price of the product. This means that for the monopolist to sell more of the product, the price must be lowered. However, the firm will produce at the quantity at which it earns the most profits possible. In a monopolistic market, the marginal revenue curve lies below the normal demand curve, and profits are maximized by producing at the level of output where marginal cost is equal to marginal revenue (MC = MR). At this level of output where the firm is producing, if the average cost (AC) curve is below the demand curve, the monopolist is making abnormal profits.

2. Using a diagram, explain the concept of a natural monopoly.

A natural monopoly is an industry in which there are only enough economies of scale available in the market to support one firm.

The economies of scale that the monopolist, hence the industry, is experiencing, set the position of the average total cost (ATC) curve. Since the monopolist’s demand curve is D₁, it can make abnormal profits when producing anywhere between q₁ and q₂. Should another firm enter the industry, the demand will decrease for both firms. The average total costs do not change, and the demand curve falls to D₂. Both firms are now earning losses, since their average total costs are higher than their average revenues. The average total cost, which is controlled by the economies of scale, will only cause the firm to earn abnormal profit if the one firm is producing all the output to satisfy all demand of the market. It is more productively efficient for society if only one firm is producing in the market. The government can regulate a firm’s decisions to achieve a more efficient allocation of resources. This mostly happens with natural monopolies, as they are often producing necessities for consumers, such as water, electricity, and gas. For example, the industry supplying electricity in Zurich, EKZ, is probably a natural monopoly.

1. Using appropriate diagrams, explain whether a monopoly is likely to be more efficient or less efficient than a firm in perfect competition.

A monopolist will produce where MR = MC, where price is forced up and profit is maximized, but will not produce at productive or allocative efficiency. Monopolists usually experience substantial economies of scale, which causes the MC curve to shift down. Due to this, the firm will produce at a higher output and a lower price than perfect competition. Monopolists make more profit, yet are less efficient than firms in perfect competition.

The monopolist produces at q, where MC = MR, to maximize profit. The price it earns per unit of output sold (P₁) is higher than the costs it faces (C), causing there to be an abnormal profit (yellow shaded area). Productive efficiency, however, is at the lowest point of AC, where MC = AC. This level of output (q₁) is not achieved. Allocative efficiency is where MC = AR. This level out output (q₂) is not achieved either.

A firm in perfect competition strives to achieve productive efficiency, which is when it produces its product at the lowest possible unit cost, and allocative efficiency, which is where suppliers are producing the optimal mix of goods and services required by consumers. The high competition for firms in perfect competition does not allow firms to produce inefficiently, because their price cannot be forced up without the firm having to exit the industry, as there is perfectly elastic demand. Because monopolists are the market, they can be less efficient than firms in perfect competition and still make profit.