Question

Explain the profit maximization rule for a monopoly. How is the rule similar and different from that of a perfectly competitive firm? What is the difference in market equilibrium price and quantity for the monopoly compared to the perfectly competitive firm?

Answer 1

The similarity between the profit maximization rule for a monopoly and the perfectly competitive firm is that both follow the same rule of MR = MC or marginal revenue marginal cost equalization. This rule maximizes the quantity to be produced because the revenue received from the last unit sold equals the cost of producing that unit

The difference between a monopoly and the perfectly competitive lies with regards to the fixation of price. For a monopoly price is determined by the demand function and the quantity established under MR = MC rule. For a competitive firm, this price is already fixed from outside and firm can only determine the quantity. The reason for this difference is also the fact that for a monopoly, P > MR = MC while for competitive firm P = MR = MC.

A monopoly produces a lower quantity and charges a higher price compared to a competitive firm. This is again because P > MR for monopoly implying that Q is reduced and P is increased

Price Assume that the given firm has market power so it faces a downward sloping demand function D and a marginal revenue function MR. The equilibrium output is determined by MR -MC rule which is therefore Qm and the resulting price is Pm. Consumer surplus is the area ABPm and producer surplus is the area PmBFIK. There is a deadweight loss due to inefficiency in price and marginal cost and is shown by area BFF. This is the case with the monopoly MC Pm TC In contrast, competitive outcome has P - MC rule which is satisfied at E. This gives a lower price Pc and a higher quantity Qc. There is no inefficiency now because P -MC. Consumer surplus is AEPc and producer surplus is PcEFIK. ATC Comparing the two market structures, the consumer surplus is greater under pure competition and producer surplus is greater under monopoly. There is welfare loss in monopoly and due to this the monopolist is able to earn greater economic profit given by the area PmBGATC Qm Qc Quantity