Economic profit for a monopoly | Microeconomics | Khan Academy

In this video, we're going to think about the economic profit of a monopoly firm. To do that, we're going to 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.

We can first think about the demand for this monopoly firm's product. The demand curve would look similar to other demand curves we've seen multiple times: at a high price, people wouldn't want a lot; they wouldn't be demanding a lot. Then, at a lower price, as price goes lower, people are going to demand a higher and higher quantity. 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, in the extreme case, is a monopoly. It 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. 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.

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. If this is unfamiliar to you, I encourage you to watch some of those videos that go into depth on why this is happening. Therefore, 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 consider 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. So, your marginal cost curve might look something like that.

The rational quantity you produce is as long as your incremental revenue for every unit is higher than your incremental cost for every unit. You would want to produce more and more and more until the point that your marginal cost is equal to your marginal revenue. 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 doing a situation where the firm, at least on the producer side, is the only producer. It is 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.

Once again, we could call that the market price. 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 can see it right over there that this quantity price is greater than marginal cost.

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. This also introduces an idea of deadweight loss. Because, at least in theory, at a higher quantity, people were willing to pay more than the marginal cost. You would think that there is some type of benefit that the market as a whole could gain from that incremental unit or those incremental units.

Then, even some more incremental units, it feels like there's to gain. But because of what is rational for this monopoly firm and the insurmountable barriers for entry for other people to enter, this is not going to be captured until you have this deadweight loss.

Now, an interesting question, and this is where I started off, is what would be the economic profit for this monopoly firm? To think about that, we have to consider the average total cost curve. 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.

As soon as marginal cost is higher than average total cost, well, now, of course, the average total cost is going to start trending upwards. So, marginal cost intersects the average total cost curve at the minimum point right over there. 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. If you were to multiply it times the number of units, well, that's going to give you its economic profit. You could view the economic profit in this situation as being this shaded area of this rectangle.

So, I'll leave you there. The big thing to appreciate is when we're dealing with imperfect competition in the extreme form of a monopoly, your marginal revenue curve is no longer your demand curve. Your marginal revenue curve is downward sloping like this. It's not the flat curve that we saw with perfect competition.

Because of that, your marginal cost is going to intersect marginal revenue at a quantity where price is greater than marginal cost, which introduces deadweight loss in the market. The way to think about the economic profit is to compare what that price in the market is of that quantity to the average total cost at that quantity. What's also interesting about this monopoly firm is that 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. 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.