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Economic profit for a monopoly

Learn about the economic profit of a monopoly firm. See how the marginal revenue curve differs from the demand curve in imperfect competition, leading to a markup and dead weight loss. The economic profit is determined by comparing the market price to the average total cost at a certain quantity. Monopolies can maintain economic profit due to high barriers to entry.

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Video transcript

- [Instructor] In this video, we're going to think about the economic profit of a monopoly, of a monopoly firm. And to do that, we're gonna draw our standard price and quantity axes, so that's quantity, and this is price. And this is going to of course be in dollars, and we can first think about the demand for this monopoly firm's product. And the demand curve would look similar to other demand curves that we've seen multiple times, that at a high price, people wouldn't be demanding a lot, and then at a lower price, or as price goes lower, people are going to demand a higher and higher quantity, or the market will demand a higher, and higher quantity. So that might be the demand curve. Now what's interesting about any imperfectly competitive firm, and the extreme case is a monopoly, is what the marginal revenue curve looks like given this demand curve. In a perfectly competitive firm, the marginal revenue curve is equal to the demand curve, and in that situation, it's actually a horizontal line. But here, because when the monopoly firm reduces price, it doesn't just reduce it on that incremental unit, it would be typical that it would have to reduce its price on all of the units, and we've studied this in other videos. You have a marginal revenue curve that would go down faster than the demand curve, it would look something like this, and if this is unfamiliar to you, I encourage you to watch some of those videos that go into depth why this is happening. So it's a monopoly, or actually any imperfectly competitive firm, its marginal revenue curve will go down faster than the demand curve. So what would be a rational quantity for this firm to produce? Well to think about that, we have to think about its marginal cost curve. So its marginal cost curve, the typical way we often think about it is, at first you get some economies of scale, but then you start having coordination costs, and maybe some diseconomies of scale, your inputs start getting more expensive, and so your marginal cost curve might look something like that. And the rational quantity produced is, as long as your incremental revenue for every unit is higher than your incremental cost for every unit, you would wanna produce more, and more, and more, and more until the point that your marginal cost is equal to your marginal revenue. And so the rational quantity to produce right over here would be right over there. I'll do that Q, I could call that Q for the firm, I could also call that Q sub M, because we're dealing with a situation where the firm is, at least from the producer side, it is the market, it is the only producer, it's a monopoly. But what's the price here? Well to know that, we just have to look at the demand curve. At this quantity, the price is right over here. So the price is right over here, and once again, we could call that the market price, and so something interesting has happened here for the monopoly firm. In a perfectly competitive firm, where the marginal cost and demand curves intersect, that's what dictated the demand, because the demand curve and the marginal revenue curve were the same. But here, we are now producing a quantity less than that, we're producing a quantity where price is greater than marginal cost, you could see it right over there. At this quantity price is greater than marginal cost, and so you can view this difference right over here as kind of a markup that is possible for a monopoly firm to do that would not be possible with a perfectly competitive firm. And this also introduces an idea of dead weight loss. Because at least in theory, at a higher quantity, people were willing to pay more than the marginal cost, so you would think that there is some type of a benefit that the market as a whole could gain from that incremental unit, or those incremental units, and then even some more incremental units. It feels like there's to gain, but because of what is rational for this monopoly firm, and there's insurmountable barriers for entry for other people to enter, this is not going to be captured until you have this dead weight loss. Now an interesting question, and this is where I started off is, well what would be the economic profit for this monopoly firm? And to think about that, we have to think about the average total cost curve. And so the average total cost, I'll draw a typical average total cost curve, it might look something like this. While marginal cost is below the average total cost, the average total cost will trend downwards, and as soon as marginal cost is higher than average total cost, well now of course, average total cost is going to start trending upwards. So marginal costs intersects the average total cost curve at the minimum point right over there. And so based on this average total cost curve, it looks like this monopoly firm is earning an economic profit, because at that quantity, this is the price per unit it's getting. This is the average cost per unit, so on average per unit, it's getting this height, it's getting this difference right over here, and then if you were to multiply it times the number of units, well that's going to give you its economic profit. So you could view the economic profit in this situation as being this shaded area of this rectangle. So I'll leave ya there. The big thing to appreciate is, when we're dealing with imperfect competition, and the extreme form of a monopoly, your marginal revenue curve is no longer your demand curve, and your marginal revenue curve is downward sloping like this, it's not the flat curve that we saw with the perfect competition. And because of that, your marginal cost is going to intersect marginal revenue at a quantity where price is greater than marginal cost, which introduces dead weight loss in the market, and the way to think about the economic profit is to compare what that price in the market is at that quantity, to the average total cost at that quantity. And what's also interesting about this monopoly firm is because of the barriers to entry, we talked about in the long run with perfect competition, if there's economic profit going on, more entrants would enter into the market, but that's not going to happen in a monopoly because the barriers to entry are so high. So this monopoly is sitting pretty, it's going to be able to keep earning this type of economic profit, unless something dramatically changes in the market somehow.