Answered by Javier P. Answered by Chen Z. Answered by Tom J. Payment Security. But a monopolist often has fairly reliable information about how changing output by small or moderate amounts will affect its marginal revenues and marginal costs, because it has had experience with such changes over time and because modest changes are easier to extrapolate from current experience.
A monopolist can use information on marginal revenue and marginal cost to seek out the profit-maximizing combination of quantity and price. The first four columns of Table 3 use the numbers on total cost from the HealthPill example in the previous exhibit and calculate marginal cost and average cost. This monopoly faces a typical upward-sloping marginal cost curve, as shown in Figure 3. The second four columns of Table 3 use the total revenue information from the previous exhibit and calculate marginal revenue.
Notice that marginal revenue is zero at a quantity of 7, and turns negative at quantities higher than 7. It may seem counterintuitive that marginal revenue could ever be zero or negative: after all, does an increase in quantity sold not always mean more revenue?
For a perfect competitor, each additional unit sold brought a positive marginal revenue, because marginal revenue was equal to the given market price.
But a monopolist can sell a larger quantity and see a decline in total revenue. When a monopolist increases sales by one unit, it gains some marginal revenue from selling that extra unit, but also loses some marginal revenue because every other unit must now be sold at a lower price.
As the quantity sold becomes higher, the drop in price affects a greater quantity of sales, eventually causing a situation where more sales cause marginal revenue to be negative. A monopolist can determine its profit-maximizing price and quantity by analyzing the marginal revenue and marginal costs of producing an extra unit.
If the marginal revenue exceeds the marginal cost, then the firm should produce the extra unit. For example, at an output of 3 in Figure 3 , marginal revenue is and marginal cost is , so producing this unit will clearly add to overall profits.
At an output of 4, marginal revenue is and marginal cost is , so producing this unit still means overall profits are unchanged. However, expanding output from 4 to 5 would involve a marginal revenue of and a marginal cost of , so that fifth unit would actually reduce profits. Thus, the monopoly can tell from the marginal revenue and marginal cost that of the choices given in the table, the profit-maximizing level of output is 4.
Indeed, the monopoly could seek out the profit-maximizing level of output by increasing quantity by a small amount, calculating marginal revenue and marginal cost, and then either increasing output as long as marginal revenue exceeds marginal cost or reducing output if marginal cost exceeds marginal revenue. This process works without any need to calculate total revenue and total cost. If you find it counterintuitive that producing where marginal revenue equals marginal cost will maximize profits, working through the numbers will help.
Step 1. Remember that marginal cost is defined as the change in total cost from producing a small amount of additional output. Step 2. As a result, the marginal cost of the second unit will be:. Step 3. Remember that, similarly, marginal revenue is the change in total revenue from selling a small amount of additional output.
Step 4. As a result, the marginal revenue of the second unit will be:. Table 4 repeats the marginal cost and marginal revenue data from Table 3 , and adds two more columns: Marginal profit is the profitability of each additional unit sold. It is defined as marginal revenue minus marginal cost. Finally, total profit is the sum of marginal profits.
As long as marginal profit is positive, producing more output will increase total profits. When marginal profit turns negative, producing more output will decrease total profits. Total profit is maximized where marginal revenue equals marginal cost. In this example, maximum profit occurs at 4 units of output. It is straightforward to calculate profits of given numbers for total revenue and total cost.
Figure 5 illustrates the three-step process where a monopolist: selects the profit-maximizing quantity to produce; decides what price to charge; determines total revenue, total cost, and profit. The firm can use the points on the demand curve D to calculate total revenue, and then, based on total revenue, calculate its marginal revenue curve. The monopolist will charge what the market is willing to pay.
A dotted line drawn straight up from the profit-maximizing quantity to the demand curve shows the profit-maximizing price. This price is above the average cost curve, which shows that the firm is earning profits. Total revenue is the overall shaded box, where the width of the box is the quantity being sold and the height is the price.
In Figure 4 , the bottom part of the shaded box, which is shaded more lightly, shows total costs; that is, quantity on the horizontal axis multiplied by average cost on the vertical axis. The larger box of total revenues minus the smaller box of total costs will equal profits, which is shown by the darkly shaded box. In a perfectly competitive market, the forces of entry would erode this profit in the long run.
But a monopolist is protected by barriers to entry. In fact, one telltale sign of a possible monopoly is when a firm earns profits year after year, while doing more or less the same thing, without ever seeing those profits eroded by increased competition. The marginal revenue curve for a monopolist always lies beneath the market demand curve.
To understand why, think about increasing the quantity along the demand curve by one unit, so that you take one step down the demand curve to a slightly higher quantity but a slightly lower price.
A demand curve is not sequential: It is not that first we sell Q 1 at a higher price, and then we sell Q 2 at a lower price. Rather, a demand curve is conditional: If we charge the higher price, we would sell Q 1. If, instead, we charge a lower price on all the units that we sell , we would sell Q 2. Graph 30 Impact of Technology on Total Production. Graph 31 Impact of Technology on Marginal Production. The next section describes how marginal cost illustrates the firm's supply of the output.
Agriculture Law and Management Accessibility. Info Share. A manager maximizes profit when the value of the last unit of product marginal revenue equals the cost of producing the last unit of production marginal cost.
So marginal analysis also tells managers what not to consider when making decisions about future resource allocation: They should ignore average costs, fixed costs, and sunk costs. For example, a toy manufacturer could try to measure and compare the costs of producing one extra toy with the projected revenue from its sale. This doesn't necessarily mean that more toys should be manufactured, however. If 1, toys were previously manufactured, then the company should only consider the cost and benefit of the 1, st toy.
Manufacturing companies monitor marginal production costs and marginal revenues to determine ideal production levels.
The marginal cost of production is calculated whenever productivity levels change. This allows businesses to determine a profit margin and make plans for becoming more competitive to improve profitability. The best entrepreneurs and business leaders understand, anticipate, and react quickly to changes in marginal revenues and costs.
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Table of Contents Expand. Calculating Marginal Cost. Reaching Optimum Production. Calculating Marginal Revenue. Can Marginal Revenue Increase?
Balancing the Scales of Marginal Revenue. When Marginal Revenue Falls. Marginal Revenue vs.
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