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Step 2: The Monopolist Decides What Price to Charge

The monopolist will charge what the market is willing to pay. A dotted line drawn straight up from the profit-maximizing quantity to the demand curve shows the profit-maximizing price. This price is above the average cost curve, which shows that the firm is earning profits.

Step 3: Calculate Total Revenue, Total Cost, and Profit

Total revenue is the overall shaded box, where the width of the box is the quantity being sold and the height is the price. In [link] , the bottom part of the shaded box, which is shaded more lightly, shows total costs; that is, quantity on the horizontal axis multiplied by average cost on the vertical axis. The larger box of total revenues minus the smaller box of total costs will equal profits, which is shown by the darkly shaded box. In a perfectly competitive market, the forces of entry would erode this profit in the long run. But a monopolist is protected by barriers to entry. In fact, one telltale sign of a possible monopoly is when a firm earns profits year after year, while doing more or less the same thing, without ever seeing those profits eroded by increased competition.

How a profit-maximizing monopoly decides price

 The graph shows monopoly profits as the area between the demand curve and the average cost curve at the monopolist’s level of output.
In Step 1, the monopoly chooses the profit-maximizing level of output Q 1 , by choosing the quantity where MR = MC. In Step 2, the monopoly decides how much to charge for output level Q 1 by drawing a line straight up from Q 1 to point R on its perceived demand curve. Thus, the monopoly will charge a price (P 1 ). In Step 3, the monopoly identifies its profit. Total revenue will be Q 1 multiplied by P 1 . Total cost will be Q 1 multiplied by the average cost of producing Q 1 , which is shown by point S on the average cost curve to be P 2 . Profits will be the total revenue rectangle minus the total cost rectangle, shown by the shaded zone in the figure.

Why is a monopolist’s marginal revenue always less than the price?

The marginal revenue curve for a monopolist always lies beneath the market demand curve. To understand why, think about increasing the quantity along the demand curve by one unit, so that you take one step down the demand curve to a slightly higher quantity but a slightly lower price. A demand curve is not sequential: It is not that first we sell Q 1 at a higher price, and then we sell Q 2 at a lower price. Rather, a demand curve is conditional: If we charge the higher price, we would sell Q 1 . If, instead, we charge a lower price (on all the units that we sell), we would sell Q 2 .

So when we think about increasing the quantity sold by one unit, marginal revenue is affected in two ways. First, we sell one additional unit at the new market price. Second, all the previous units, which could have been sold at the higher price, now sell for less. Because of the lower price on all units sold, the marginal revenue of selling a unit is less than the price of that unit—and the marginal revenue curve is below the demand curve. Tip : For a straight-line demand curve, MR and demand have the same vertical intercept. As output increases, marginal revenue decreases twice as fast as demand, so that the horizontal intercept of MR is halfway to the horizontal intercept of demand. You can see this in the [link] .

The monopolist’s marginal revenue curve versus demand curve

The graph shows that the market demand curve is conditional, so the marginal revenue curve for a monopolist lies beneath the demand curve.
Because the market demand curve is conditional, the marginal revenue curve for a monopolist lies beneath the demand curve.

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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