Short-run maximum profit: price/quantity-setting
I'm winding up to discuss how a profit-maximizing firm with no concerns beyond the present should set the price and quantity of their output, in order to maximize profit in the moment.
Note the assumptions wafting by:
- we're talking about firms with the objective of maximizing monetary profit
- we're talking about firms with no concerns beyond today
- that means that we're talking about firms that do not want to keep output relatively high and prices relatively low in order to discourage other firms from entering the industry-- really only perfectly competitive firms and natural monopolies* qualify
- that means that we're not talking about firms that decide to lower prices now to increase eventual customer base, affecting future demand
- that means that we're not talking about firms that decide to raise prices now to establish a luxury reputation that will affect future demand
But even after noticing all those assumptions we need to notice something else.
Consider backward to our discussion of opportunity cost. We noted that the higher the price of a good or service, the more of other goods and services must be forgone in order to purchase one. For that reason, in general we would expect that the higher the price of a good or service, the fewer units of it will be demanded by buyers.**
Which is to say that the demand curve, which tracks market demand for a good as its price changes, slopes downward.
Picture of a demand curve.
A monopolistic firm is Lord of the Demand Curve. Its decisionmakers know that, typically, to sell another unit of output, they will have to accept a lower price-- for all units sold, unless they are informationally and legally able to offer different prices to different customers. (This is called price discrimination, and is formally illegal in the U.S.)
So, in economists' models, the profit-maximizing monopolist will produce more output and accept a lower per-unit price as long as producing that extra unit adds no more to the firm's costs than it does to the firm's total revenue. Because as long as producing and selling an extra unit increases total revenue more than it increases total costs of production, profit is growing.
As with many decisions, economists are modelling this choice of output as a marginal decision. What producing one more unit adds to costs is called marginal cost. What selling one more unit adds to firm revenue is called marginal revenue.
Note again: the monopolist can only expect to sell more output by accepting a lower price for output. (For all units, unless it can price-discriminate.) That means that, for a monopolist, selling an additional unit adds less to total revenue than the price the additional unit is sold at-- because it drives down the price at which all other units are sold.
The situation of a perfectly competitive firm maximizing profits in the moment is different. That firm will also produce output as long as its marginal cost is no higher than its marginal revenue. But a perfectly competitive firm is so small relative to the market that it has no effect on market price-- it can sell as many units as it wants at the market price. The marginal cost of that profit-maximizing perfectly competitive firm is equal to the price consumers pay.
This is an efficiency condition. The last unit produced in a perfectly competitive market cost exactly the amount buyers value the output at. There is no desire-to-buy that would pay for the cost of an extra unit.
Since the profit-maximizing monopolist's marginal revenue is less than the price buyers are paying, when it stops producing at a marginal cost equal to its marginal revenue and less than the price buyers pay, there is unexhausted willingness-to-pay in the market.***
That is, compared with benchmark perfectly competitive producers, monopolists produce too little output and charge too much.
Which is, classically, why they have gotten regulated.
* Natural monopolies will be discussed before long.
** It is theoretically possible that this will not occur, but it's not clear that demand for any good in any market has ever increased as its price rose.
*** Price discrimination eliminated this problem. But it takes a lot of information, isn't always technically possible, and is at least formally non-legal in many places.
Facebook posts incorporated:
Short-run profit-maximizing: Underlying assumptions about firms; the nature of market demand
Monopoly pricing in the short run
Social inefficiency of monopoly compared with perfect competition
Note the assumptions wafting by:
- we're talking about firms with the objective of maximizing monetary profit
- we're talking about firms with no concerns beyond today
- that means that we're talking about firms that do not want to keep output relatively high and prices relatively low in order to discourage other firms from entering the industry-- really only perfectly competitive firms and natural monopolies* qualify
- that means that we're not talking about firms that decide to lower prices now to increase eventual customer base, affecting future demand
- that means that we're not talking about firms that decide to raise prices now to establish a luxury reputation that will affect future demand
But even after noticing all those assumptions we need to notice something else.
Consider backward to our discussion of opportunity cost. We noted that the higher the price of a good or service, the more of other goods and services must be forgone in order to purchase one. For that reason, in general we would expect that the higher the price of a good or service, the fewer units of it will be demanded by buyers.**
Which is to say that the demand curve, which tracks market demand for a good as its price changes, slopes downward.
Picture of a demand curve.
A monopolistic firm is Lord of the Demand Curve. Its decisionmakers know that, typically, to sell another unit of output, they will have to accept a lower price-- for all units sold, unless they are informationally and legally able to offer different prices to different customers. (This is called price discrimination, and is formally illegal in the U.S.)
So, in economists' models, the profit-maximizing monopolist will produce more output and accept a lower per-unit price as long as producing that extra unit adds no more to the firm's costs than it does to the firm's total revenue. Because as long as producing and selling an extra unit increases total revenue more than it increases total costs of production, profit is growing.
As with many decisions, economists are modelling this choice of output as a marginal decision. What producing one more unit adds to costs is called marginal cost. What selling one more unit adds to firm revenue is called marginal revenue.
Note again: the monopolist can only expect to sell more output by accepting a lower price for output. (For all units, unless it can price-discriminate.) That means that, for a monopolist, selling an additional unit adds less to total revenue than the price the additional unit is sold at-- because it drives down the price at which all other units are sold.
The situation of a perfectly competitive firm maximizing profits in the moment is different. That firm will also produce output as long as its marginal cost is no higher than its marginal revenue. But a perfectly competitive firm is so small relative to the market that it has no effect on market price-- it can sell as many units as it wants at the market price. The marginal cost of that profit-maximizing perfectly competitive firm is equal to the price consumers pay.
This is an efficiency condition. The last unit produced in a perfectly competitive market cost exactly the amount buyers value the output at. There is no desire-to-buy that would pay for the cost of an extra unit.
Since the profit-maximizing monopolist's marginal revenue is less than the price buyers are paying, when it stops producing at a marginal cost equal to its marginal revenue and less than the price buyers pay, there is unexhausted willingness-to-pay in the market.***
That is, compared with benchmark perfectly competitive producers, monopolists produce too little output and charge too much.
Which is, classically, why they have gotten regulated.
* Natural monopolies will be discussed before long.
** It is theoretically possible that this will not occur, but it's not clear that demand for any good in any market has ever increased as its price rose.
*** Price discrimination eliminated this problem. But it takes a lot of information, isn't always technically possible, and is at least formally non-legal in many places.
Facebook posts incorporated:
Short-run profit-maximizing: Underlying assumptions about firms; the nature of market demand
Monopoly pricing in the short run
Social inefficiency of monopoly compared with perfect competition