Say you opened a candy store on a block where every store sells candy. Each shop sells a Hershey bar for one dollar. Do you think your business will succeed if you sell the same Hershey bar for a dollar and 50 cents?
I’ll assume you said no. Good answer. When there’s competition, you have to accept the price the market agrees on. If you pick a higher price than that, your customers will ignore you in favor of your competitors.
Do you think your business will succeed if you sell the bar for 50 cents?
You said no again. Good answer again. When there’s competition, firms will try to make their prices as low as they possibly can so other sellers won’t undercut them. If you pick a lower price than that, the money you make relative to the costs would not be worth it.
Now imagine you are the only candy store in a 10 mile radius. In that case, could you succeed if you sell it for a dollar and 50 cents?
You said yes this time. You’re on a roll today. When there’s no competition, you don’t have to worry about being undercut. You get to pick the price.
Note how in the last two graphs, the marginal revenue curve is flat under perfect competition, and downward sloping under a monopoly.
What is marginal revenue? It is the additional revenue you get from selling the last unit of a good.
If you sell 9 chocolate bars, and make 9 dollars, and then sell 10 chocolate bars, and make 10 dollars, your marginal revenue at 10 bars is 1 dollar. Because you made 1 dollar more by selling the 10th bar. Under perfect competition, the marginal revenue will always equal the market price. That’s why the curve is flat.
In a monopoly scenario, how many customers you attract and your marginal revenue will be determined by the price you choose. If selling a bar for $1 attracts 16 customers, then selling it for $0.95 will attract more customers. Selling 16 for $1 would make you 16 dollars. If you sell 17 for $0.95 and make 16 dollars and 15 cents, then your marginal revenue for the 17th bar is 15 cents. If you sell 15 for $1.05 and make 15 dollars and 75 cents, compare that to the 16 dollars earlier, and your marginal revenue for the 16th bar is 25 cents. Marginal revenue is, again, the additional revenue you get from selling the last unit of a good.
The marginal revenue curve (of different price points under a monopoly) is downward sloping because the more units you offer for a good, the less people will want each additional unit. The price has to be lowered in order for people to buy the additional unit.
If the additional revenue from selling your 30th bar is 2 cents, but the additional cost of selling it is 2 dollars, should you sell it?
I say no. Good job me, that’s correct. A firm should not sell an extra unit of a good if the additional revenue they get is lower than the additional cost.
The additional cost/marginal cost is represented by the supply curve. The curve is upward sloping because when a firm produces more, costs increase. There are diminishing returns from single fixed inputs, high costs in adding more fixed inputs, the opportunity costs of not selling something else, etc. In the case of your store, there’s a limit to how much room you have for your Hershey bars (considering the other products you have), it would be expensive for you to rent out more space for those bars, and any Hershey chocolate bar you display is stealing attention from another type of candy or product (that may produce a higher marginal revenue). The more Hershey bars you want to sell, the higher your accounting and opportunity costs will be. So the marginal cost/supply curve is upward sloping.
Don’t worry if you didn’t digest any of that; there will be an entire page dedicated to the supply line later in the course. The point is that generally, as the quantity you intend to sell increases, marginal cost will be increasing, while marginal revenue will either be constant or decreasing.
For any firm, the profit-maximizing quantity is the quantity where the marginal/additional cost curve reaches the marginal/additional revenue curve, or in other words, where marginal cost equals marginal revenue.
When there is perfect competition, marginal revenue is equal to marginal cost at the quantity where demand intersects supply. At this quantity, buyers buy and sellers sell as much as they can, given the constraints of the market.
When there is a monopoly however, the marginal revenue curve and the supply curve intersect at a lower quantity. Even worse, the profit-maximizing monopoly will pick the highest price that people will be willing to pay, meaning the price will be the value on the demand line above the MR-MC intersection.
The money made from the highest price the monopoly could sell for minus the lowest price it could sell for is known as economic profit. It’s money the firm got not because it had to cover the costs of capital and labor of its last unit sold, but because it wanted it and it had the pricing power to get it.
Note: The total economic profit is the highest possible price minus the lowest possible price, times the quantity. Or in other words, the area of the rectangle. Here, it’s 1.25 dollars minus 75 cents, which is 50 cents, times 11, making it a total economic profit of $5.50. This is out of the total revenue of (the quantity 11 times the price 1.25, or:) $13.75.
Before you start praying to God and the government to punish monopolies for raising their prices and making undue profits, maybe it would be a good idea to first ask: Are profits always a bad thing?
The profit motive is often a driver for innovation. The reason companies in America are creative with the products they introduce is because they know they can patent or trademark them. That means nobody can sell the exact same product, and so a company is able to make monopolistic profits by being the only firm that can sell their product. If you were an entrepreneur, and you knew you could make more profits with original ideas than with copied ones, you would try to invent great things: better tasting burgers, faster operating systems, novel tv catchphrases, etc. Without the legal protection and monetary incentive however, you will avoid being the creative person, because your ideas will be stolen and you won’t be properly rewarded for coming up with them in the first place.
If you wanna know why America is considered a great country, why it created things like the telephone, the automobile and the show Breaking Bad, I have two words for you: profit motive.
Another great thing about the profit motive is that it motivates entrepreneurs to take risks. If you’re the only person to open a candy store in a neighborhood where entrepreneurs are afraid to open candy stores, you deserve whatever profits you make.
… Okay, despite all the good things I just said, I believe all monopolistic profits should be outlawed. No exceptions. I am not saying that just to be politically correct… Heh heh, like why would I do that? Monopolies suck. Boooo! Everybody jeer!
When I talked about the bevy of candy stores on the same block earlier, I was implying a few things about perfect competition: that all sellers are the same, that the product they sell are the same, that there are a large number of sellers and that there are a large number of buyers. Such conditions rarely exist in the real world.
Likewise, being a sole candy store with zero competition is not common either. As soon as you join a market and are successful, new firms will follow suit. And even if they don’t follow suit, you still have to compete with close substitutes, such as pastries. Why would I want a chocolate bar for $2.25 when I can get a chocolate donut for 50 cents? Just because you have monopolistic power doesn’t mean you have zero competition.
There may be some exceptions. The selling of stocks for a public traded company for example often meet all the requirements for perfect competition. Likewise, electric companies who provide all the energy needs for particular towns tend to have no competitors and qualify as total monopolies. However markets typically don’t fit either description. Most markets exist somewhere between these two extremes.
The hybrid of the two, what exists more often in the real world, is known as monopolistic competition.
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