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6.5 Equilibrium Condition for a Monopoly Firm

Profit of a Firm
 
•The profit received by the firm equals the total revenue(TR) minus the total cost (TC).
•If quantity q1 is produced, the total revenue is TR1 and total cost is TC1.
•The difference, TR1 – TC1, is the profit received.
•The same is depicted by the length of the line segment AB, i.e., the vertical distance between the TR and TC curves at q1 level of output.
 
Profit and Loss
 
•When output level is less than q2, the TC curve lies above the TR curve, i.e., TC is greater than TR, and therefore profit is negative and the firm makes losses.
•The same situation exists for output levels greater than q3.
•Hence, the firm can make positive profits only at output levels between q2 and q3,
 
Behaviour of a monopoly firm
 
•The monopoly firm will choose that level of output which maximises its profit.
•This would be the level of output for which the vertical distance between the TR and TC is maximum and TR is above the TC, i.e., TR – TC is maximum.
•This occurs at the level of output q0.
•Profit of the curve is plotted in the curve, which achieve maximum at q0.
•Profit of the monopoly firm is maximum at q0.
•The price at which this output is sold is the price consumers are willing to pay for this q0 quantity of the commodity.
•Hence, the monopoly firm will charge the price corresponding to the quantity level q0 on the demand curve.
 
Analysis using Average and Marginal curves
•The analysis of monopoly firm can also be conducted using Average and Marginal Revenue and Average and Marginal Cost.
•In Figure, the Average Cost (AC), Average Variable Cost (AVC) and Marginal Cost (MC) curves are drawn along with the Demand (Average Revenue) Curve and Marginal Revenue curve.
•At quantity level below q0, the level of MR is higher than the level of MC.
•Therefore, if the firm is producing a level of output less than q0, it would desire to increase its output since that would add to its profits.
 
Using Average and Marginal curves
•At quantity level below q0, the level of MR is higher than the level of MC.
•Hence, the increase in total revenue from selling an extra unit of the commodity is greater than the increase in total cost for producing the additional unit.
•This implies that an additional unit of output would create additional profits since Change in profit = Change in TR – Change in TC.
•When the firm reaches an output level of q0, MR equals MC and increasing output provides no increase in profits.
•If the firm was producing a level of output which is greater than q0, MC is greater than MR.
•Hence, lowering of total cost by reducing one unit of output is greater than the loss in total revenue due to this reduction.
•It is therefore advisable for the firm to reduce output.
 
Equilibrium level of output
 

•At qo the firm will make maximum profits.
•It has no incentive to change from qo.
•This level is called the equilibrium level of output.
•Since this equilibrium level of output corresponds to the point where the MR equals MC, this equality is called the equilibrium condition for the output produced by a monopoly firm.
 
Average and Total Cost
 

•At this equilibrium level of output q0, the average cost is given by the point ‘d’ where the vertical line from q0 cuts the AC curve.
•The average cost is thus given by the height dq0.
•Since total cost equals the product of AC and the quantity produced being q0, the same is given by the area of the rectangle Oq0dc.
 
Average Revenue of firm
 

•Once the quantity of output produced is determined, the price at which it is sold is given by the amount that the consumers are willing to pay, as expressed through the market demand curve.
•Thus, the price is given by the point ‘a’ where the vertical line through q0 meets the market demand curve D.
•Thus the price aq0 is the revenue per unit of output or the Average Revenue for the firm.
•The total revenue is the area of the rectangle Oq0ab.
 
Profit of monopoly firm
•The total revenue is the area of the rectangle Oq0ab.
•The area of the rectangle Oq0ab is larger than the area of the rectangle Oq0dc, i.e., TR is greater than TC.
•The difference is the area of the rectangle cdab i.e.  Profit = TR – TC  
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