Imagine you went to buy olive oil and saw that its price has increased significantly. Then you decided to have a look at other alternatives and couldn't find one. What would you do? You will probably end up buying the olive oil as it is a daily essential to cook food. In this case, the olive oil company has a monopoly in the market and can influence the price as it wishes. Sounds interesting right? In this article, you'll learn more about monopoly profit and how the firm can maximize it.
Monopoly Profit Theory
Before we go over the theory of monopoly profit, let's have a quick review of what a monopoly is. The situation when there is only a single seller in the market who sells products that are not easily substitutable is known as a monopoly. The seller in a monopoly does not have any competition and can influence the price as per their requirement.
A monopoly is a situation where there is a single seller of a non-substitutable product or service.
One of the major causes of monopoly is barriers to entry that make it very hard for new firms to enter the market and compete with the existing seller. The barriers to entry can be due to government regulation, unique process of production or having a monopoly resource.
Need a refresher on monopoly? Check out the following explanations:
- Monopoly
- Monopoly Power
- Government Monopoly
Assume that, Alex is the only coffee beans supplier in the city. Let's have a look at the table below, which illustrates the relationship between the quantity of coffee beans supplied, and the revenue earned.
| Quantity (Q) | Price (P) | Total Revenue (TR) | Average Revenue(AR) | Marginal Revenue(MR) |
| 0 | $110 | $0 | - | |
| 1 | $100 | $100 | $100 | $100 |
| 2 | $90 | $180 | $90 | $80 |
| 3 | $80 | $240 | $80 | $60 |
| 4 | $70 | $280 | $70 | $40 |
| 5 | $60 | $300 | $60 | $20 |
| 6 | $50 | $300 | $50 | $0 |
| 7 | $40 | $280 | $40 | -$20 |
| 8 | $30 | $240 | $30 | -$40 |
Table 1 - How the coffee bean monopolist's total and marginal revenues change as the quantity sold increases
In the above table, column 1 and column 2 represent the monopolist's quantity-price schedule. When Alex produces 1 box of coffee beans, he can sell it for $100. If Alex produces 2 boxes, then he must reduce the price to $90 to sell both boxes, and so on.
Column 3 represents the total revenue, which is calculated by multiplying the quantity sold and the price.
\(\hbox{Total Revenue (TR)}=\hbox{Quantity (Q)}\times\hbox{Price(P)}\)
Similarly, column 4 represents average revenue, which is the amount of revenue the firm receives for each unit sold. The average revenue is calculated by dividing the total revenue by the quantity in column 1.
\(\hbox{Average Revenue (AR)}=\frac{\hbox{Total Revenue(TR)}} {\hbox{Quantity (Q)}}\)
Lastly, column 5 represents the marginal revenue, which is the amount the firm receives when each additional unit is sold. The marginal revenue is calculated by calculating the change in total revenue when one additional unit of product is sold.
\(\hbox{Marginal Revenue (MR)}=\frac{\Delta\hbox{Total Revenue (TR)}}{\Delta\hbox{Quantity (Q)}}\)
For example, when Alex increases the quantity of coffee beans sold from 4 to 5 boxes, the total revenue he receives increases from $280 to $300. The marginal revenue is $20.
Hence, the new marginal revenue can be illustrated as;
\(\hbox{Marginal Revenue (MR)}=\frac{$300-$280}{5-4}\)
\(\hbox{Marginal Revenue (MR)}=\$20\)
Monopoly Profit Demand Curve
The key to monopoly profit maximization is that the monopolist faces a downward-sloping demand curve. This is the case because the monopolist is the only firm serving the market. Average revenue is equal to demand in the case of a monopoly.
\(\hbox{Demand (D)}=\hbox{Average Revenue (AR)}\)
Further, when the quantity is increased by 1 unit, the price has to decrease for every unit the firm sells. Therefore, the marginal revenue of the monopoly firm is less than the price. That's why a monopolist's marginal revenue curve is below the demand curve. Figure 1 below shows the demand curve and marginal revenue curve that the monopolist faces.
Fig. 1 - A monopolist's marginal revenue curve is below the demand curve
Monopoly Profit Maximization
Let's now dive deep into how a monopolist does profit maximization.
Monopoly Profit: When Marginal Cost < Marginal Revenue
In Figure 2, the firm is producing at point Q1, which is a lower level of output. Marginal cost is less than marginal revenue. In this situation, even if the firm increases its production by 1 unit, the cost incurred while producing the additional unit will be less than the revenue earned by that unit. Therefore, when the marginal cost is less than the marginal revenue, the firm can increase its profits by increasing the production quantity.
Fig. 2 - Marginal cost is less than marginal revenue
Monopoly Profit: When Marginal Revenue < Marginal Cost
Likewise, in Figure 3, the firm is producing at point Q2, which is a higher level of output. Marginal revenue is less than marginal cost. This scenario is the opposite of the scenario above. In this situation, it is favorable for the firm to decrease its production quantity. As the firm is producing a higher level of output than optimal, if the firm reduces the production quantity by 1 unit, the production cost saved by the firm is more than the revenue earned by that unit. The firm can increase its profits by decreasing its production quantity.
Fig. 3 - Marginal revenue is less than marginal cost
Monopoly Profit Maximization Point
In the two scenarios above, the firm has to adjust its production quantity to increase its profit. Now, you must be wondering, which is the point where there is maximum profit for the firm? The point where the marginal revenue and marginal cost curves intersect is the profit-maximizing quantity of output. This is Point A in Figure 4 below.
After the firm recognizes its profit-maximizing quantity point, i.e., MR = MC, it traces to the demand curve to find the price that it should charge for its product at this specific level of production. The firm should produce the quantity of QM and charge the price of PM to maximize its profit.
Fig. 4 - Monopoly profit maximization point
Monopoly Profit Formula
So, what is the formula for monopoly profit? Let's have a look at it.
We know that,
\(\hbox{Profit}=\hbox{Total Revenue (TR)} -\hbox{Total Cost (TC)}\)
We can further write it as:
\(\hbox{Profit}=(\frac{\hbox{Total Revenue (TR)}}{\hbox{Quantity (Q)}} - \frac{\hbox{Total Cost (TC)}}{\hbox{Quantity (Q)}}) \times\hbox{Quantity (Q)}\)
We know that, total revenue (TR) divided by quantity (Q) is equal to price (P) and that total cost (TC) divided by quantity (Q) is equal to the average total cost (ATC) of the firm. So,
\(\hbox{Profit}=(\hbox{Price (P)} -\hbox{Average Total Cost (ATC)})\times\hbox{Quantity(Q)}\)
By using the above formula, we can figure out the monopoly profit in our graph.
Monopoly Profit Graph
In Figure 5 below, we can integrate monopoly profit formula. The point A to B in the figure is the difference between the price and the average total cost (ATC) which is the profit per unit sold. The shaded area ABCD in the above figure is the total profit of the monopoly firm.
Fig. 5 - Monopoly profit
Monopoly Profit - Key Takeaways
- A monopoly is a situation where there is a single seller of a non-substitutable product or service.
- A monopolist's marginal revenue curve is below the demand curve, as it has to decrease the price in order to sell more units.
- The point where the marginal revenue (MR) curve and the marginal cost (MC) curve intersect is the profit-maximizing quantity of output for a monopolist.
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