Profit Maximization of Monopolistic Firm and the Term Paper

profit maximization of monopolistic firm and the benefits and disadvantages of a monopoly to a consumer.

MONOPOLY

The central theory in all of the profit-maximizing outcomes rests on the idea that marginal revenue should equal marginal cost. The same is true in the case of a firm with monopoly power. Before we discuss the profit-maximizing outcomes, it is important to understand what is meant by monopoly and how does it affect revenues and costs.

A firm has a monopoly if it is the only supplier in the industry of that particular product or products. Moreover there are no close substitutes. Therefore the consumers in this market have no choice but to buy from that one firm or not at all. For this reason, the monopolist is known as a price-maker because it has the opportunity to set prices at any desired level (Mankiw, 2000). Monopolies occur largely because of the existence of barriers to entry in a given industry. These barriers include legal barriers (patents and licenses), economic barriers and natural barriers. Under legal restrictions, government allows anyone firm a special right to manufacture or trade that particular product. This happens usually when a firm acquires a patent or a special right to market that particular product. Also sometimes the government would grant any one organization to dominate an industry such as a telecom firm that happens to be the only firm providing telecommunications services. Other barriers include control of a scarce resource or input as in the case of the South African diamond syndicate. Technical superiority as in the case of Microsoft is another barrier for other firms to make and market a similar product. Natural barrier or monopoly exists where an industry in which advantages of large-scale production make it possible for a single firm to produce the entire output of the market at lower average cost than a number of firms each producing a smaller quantity. Therefore there are two basic reasons why monopoly may exist. These are barriers to entry, such as legal restrictions and patents and cost advantages of large-scale operation. With these barriers, the monopolist is able to set a level of output that is in accordance with the rule of profit maximizing (Pindyck & Daniel, 2000). The market cannot determine the price, which a monopolist would charge the way it can for a price-taking competitive firm. However the monopolist cannot choose both price and the output. According to the demand curve, the higher the price it sets, the less it can sell. Thus, the standard supply-demand analysis does not apply in a monopolized industry. Since the monopolist firm is the only firm in that industry, therefore the market demand curve is also the demand curve for that firm's output. Hence in order to derive the profit maximization rule from the demand curve,…