Question

a) How does a firm operating under monopoly market structure determine profit maximizing output and price?                                                                                                                                                                                                                  (5 marks)b) Explain why an increase in price above the profit maximising price implies that a reduction in profits for the monopolist.

Answer 1

Part a

A monopolist can determine its profit-maximizing price and quantity by analyzing the marginal revenue and marginal costs of producing an extra unit.  The profit-maximizing choice for the monopoly will be to produce at the quantity where marginal revenue is equal to marginal cost: that is, MR = MC. If the monopoly produces a lower quantity, then MR > MC at those levels of output, and the firm can make higher profits by expanding output. If the firm produces at a greater quantity, then MC > MR, and the firm can make higher profits by reducing its quantity of output.

Part b

A profit-maximizing monopolist can’t just charge any price it wants. For a monopolist, the marginal revenue is always less than or equal to the price of the commodity. This arises because the monopolist is the only seller in the market and, thus, faces a market demand curve that is downward sloping. Due to this the price a monopolist can expect to receive for its output will not remain constant as the monopolist increases its output. The monopolist's marginal revenue will also be falling as the monopolist increases its output.The marginal revenue that the monopolist receives from producing an additional unit of output will always be less than the price that the monopolist can charge for the additional unit. As a result any price increase above the Profit Maximizing price will result in reduction in profits.