KNOW

UNDERSTAND

The long run for a MonopolistCauses of shift in D and S.

Why a Monopoly can sustain supernormal profits in the long runHow changes in supply and demand impact on this market structures

THINKING – MANAGING SELF – PARTICIPATING AND CONTRIBUTING - RELATING TO OTHERS – USING LANGUAGE, SYMBOLS and TEXT

LEVEL 3 ECONOMICS AS3.1 Understand marginal analysis and the behaviour of firms

Understanding Economics Chapter 10, P100

Long run equilibrium for a Monopoly

Learning Objectives

Many of the principles of what you have learnt about Perfect Competitors apply when you are looking at Monopolies. For example a Monopoly still maximises profit at the level of output where MR=MC, and the shapes of the MC and AC curves are the same.

I want to highlight the differences that you need to be aware of;

1. The Monopoly can maintain supernormal profits in the long run because it is the only firm.

2. The MR curve is downward sloping and cuts the horizontal axis half way between zero and where the AR=P=D curve cuts it.

We will look at Monopoly long run positions including how they impact on allocative efficiency and what happens when demand and supply conditions change.

PRICECOSTREVENUE

QUANTITY

MR

A MonopolyMC

AR=P=D

The profit maximising level of output Qmax and the price the Monopoly will receive Pe

Pe

Qmax

PRICECOSTREVENUE

QUANTITY

MR

A MonopolyMC

AR=P=D

CAUTION: A number of students get caught in the trap of labelling Pe where MC cuts MR – THIS IS WRONG

Pe

Qmax

CORRECT METHODRun up though MC=MR right up to the demand curve to illustrate the price

PRICECOSTREVENUE

QUANTITY

MR

A MonopolyMC

AR=P=D

Pe

Qmax

Remember earlier in this course we learned that the MC curve represented the supply curve for a firm?

Recall that we showed 2 graphs for a perfectly competitive situation, The

firm and the market. With a monopoly the firm is the market so we only need to look at a single graph.

PRICECOSTREVENUE

QUANTITY

MR

A MonopolyMC

AR=P=D

Pe

Qmax

Remember earlier in this course we learned that the MC curve represented the supply curve for a firm?

Recall also that the MC curve is the supply curve above breakeven. You can hopefully see that in this market (if a Monopoly did not exist) our expected equilibrium is where SUPPLY + DEMAND (the green lines, remember Level 1 eco?)

PRICECOSTREVENUE

QUANTITYMR

A MonopolyMC

AR=P=D

Pe

Qmax

Deadweight Loss

You should then be able to identify that because there is a Monopoly that will produce at Qmax, we have deadweight loss in this market. This is the loss of efficiency caused by the existence of a Monopoly situation.

PRICECOSTREVENUE

QUANTITY

MR

A MonopolyMC

AR=P=D

This is consumer surplusmaximised

We call this price and quantity combination the Social Equilibrium

You know it as the normal market equilibrium where the forces of demand and supply determine the market price.It is sometimes referred to as Marginal cost pricing because it is where MC equals P.

Now lets look at different profit situations for a

MONOPOLY

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Supernormal Profit

MC

AC

AR=P=D

Qmax

Pe

Ce

Remember that AC must cut MC at its minimum point and for a supernormal profit AC will be lower than AR

Pe is the price the firm receives for each unit sold (AR) and Ce is the Average Cost of making each unit. In this case AR < AC so the yellow area shows the supernormal profit. This is a sustainable long run position for a Monopoly

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Supernormal Profit

MC

AC

AR=P=D

The area of the red triangle is called Consumer Surplus

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Normal Profit

MCAC

AR=P=D

Qmax

Pe &Ce

Remember that AC must cut MC at its minimum point and for a supernormal profit AC will be lower than AR

Pe is the price the firm receives for each unit sold (AR) and Ce is the Average Cost of making each unit. In this case AR = AC so this is a normal profit.

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Subnormal Profit

MCAC

AR=P=D

Qmax

Pe

CeRemember that AC must cut MC at its minimum point and for a supernormal profit AC will be lower than AR

Pe is the price the firm receives for each unit sold (AR) and Ce is the Average Cost of making each unit. In this case AC < AR so the red area shows the subnormal profit. This firm would have no interest in staying in the market so would want to leave.

Now lets look at different scenarios for a MONOPOLY

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Supernormal Profit

MC

AC

AR=P=D

Qmax

Pe

Ce

SCENARIO 1: What would happen if there was an increase in demand in this market?

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Supernormal Profit

MC

AC

AR=P=D

Qmax

Pe

Ce

SCENARIO 1: An increase in DemandShift the demand curve (AR=P=D) right – the MR curve must move too. Remember it cuts half way.

AR1=P1=D1

MR1

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Supernormal Profit

MC

AC

AR=P=D

Qmax

Pe

Ce

SCENARIO 1: An increase in DemandDO YOU KNOW what effect the level of dmenad has on the Monopoly?? Lets take a look!

AR1=P1=D1

MR1

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Supernormal Profit

MC

AC

AR=P=DQmax

Pe

Ce

SCENARIO 1: An increase in DemandQmax is now not the profit maximising level of output, So we need to move to where MR = MC (Qmax1)

AR1=P1=D1

MR1Qmax1

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Supernormal Profit

MC

AC

AR=P=DQmax

Pe

Ce

SCENARIO 1: An increase in DemandThis firm will enjoy an increased price, no change in costs, and increase in revenue and a much larger supernormal profit

AR1=P1=D1

MR1Qmax1

Remember you will be asked to explain what the Monopoly will do based on marginal analysis

Like this;After demand increased in this market the Monopoly was no

longer producing at the profit maximising level of output (I hope you have memorised this term by now?). The firm should increase its output as currently its MR is greater than its MC so there are additional marginal profits to be made. They should continue to increase output to the point where MC = MR which will be its new profit maximising level of output.

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Supernormal Profit

MC

AC

AR=P=D

Qmax

Pe

Ce

SCENARIO 2: What would happen if variable costs increased in this market?

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Supernormal Profit

MC

AC

AR=P=D

Qmax

Pe

Ce

SCENARIO 2: variable costs increased As you know variable costs affect marginal costs and will affect AC.Do you think you know what will happen? Lets take a look.

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Supernormal Profit

MC

AC

AR=P=D

Qmax

Pe

Ce

SCENARIO 2: variable costs increased When variable costs increase we lift the MC curve directly upwards.

MC1

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Supernormal Profit

MC

AC

AR=P=D

Qmax

Pe

Ce

SCENARIO 2: variable costs increased The AC curve will havre to move as well to reflect the change in costs. Remember it must cut the MC curve at the minimum point.

MC1

AC1

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Supernormal Profit

MC

AC

AR=P=D

Qmax

Pe

Ce

SCENARIO 2: variable costs increased What should the Monopolist do now?

MC1

AC1

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Supernormal Profit

MC

AC

AR=P=DQmax

Pe

Ce

SCENARIO 2: variable costs increased Qmax is now no longer the profit maximising level of output, so identify and label the new Qmax.

MC1

AC1

Qmax1

Pe1

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Supernormal Profit

MC

AC

AR=P=DQmax

Pe

Ce

SCENARIO 2: variable costs increased Now as a result of this change in output what is the profit situation of the Monopolist? Label the new profit, it’s the green shaded area.

MC1

AC1

Qmax1

Pe1Ce1

Try and ignore all the fact that the diagram looks complicated. Just look for the key points and label correctly.

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Supernormal Profit

MC

AC

AR=P=DQmax

Pe

Ce

SCENARIO 2: variable costs increased The Monopolist in this situation will find themselves making a much lower level of supernormal profit

MC1

AC1

Qmax1

Pe1Ce1

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Supernormal Profit

MC

AC

AR=P=D

Qmax

Pe

Ce

SCENARIO 3: What would happen if fixed costs increased in this market?

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Supernormal Profit

MC

AC

AR=P=D

Qmax

Pe

Ce

SCENARIO 3: fixed costs increaseThis has no effect on MC so only the AC curve will move. Recall that it slides up the MC curve.

AC1

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Supernormal Profit

MC

AC

AR=P=D

Qmax

Pe

Ce

SCENARIO 3: fixed costs increaseYou will identify quite quickly that Qmax does not change.

AC1

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Supernormal Profit

MC

AC

AR=P=D

Qmax

Pe

Ce

SCENARIO 3: fixed costs increaseYou should also see in this case that AC now cuts the Demand curve or AR so AC=AR after fixed costs increase. This has eliminated the supernormal profit

AC1

PRICECOSTREVENUE

QUANTITYMR

A Monopoly making Supernormal Profit

MC

AR=P=D

Qmax

PeCe

SCENARIO 3: fixed costs increaseYou should also see in this case that AC now cuts the Demand curve or AR so AC=AR after fixed costs increase. This has eliminated the supernormal profit

AC1The monopolist in this case will look for opportunities to raise the price and return to supernormal profit.