Question

Evaluate the statement: it is possible that an economic shock would cause the monopoly to experience economic loss (negative economic profit). Answer this by drawing curves and explaining them in words.

Answer 1

Yes, it is possible that a negative economic shock could cause the monopoly to experience economic loss.

A monopoly that was initially making profits, could later on face losses.

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This may happen due to various reasons, but the main reason is an event that has raised its average total costs. For example, a sudden rise in the cost of production - caused by an external event, like rise in crude oil prices, a natural disaster, a strike by laborers, war-like situation, political turmoil, and so on.

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First, consider the following monopoly making profits:

In the above diagram, the downward sloping Demand and MR curves can be seen. MC and ATC are U-shaped. MC intersects ATC at its minimum point. The intersection of MR and MC determine the profit maximizing quantity, and price is set accordingly as per the demand curve.

The difference between P and ATC determines the profit margin. The profit area is shown as the pink rectangle.

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Now due to a negative shock to the cost of production, the ATC curve rises drastically.

Note that the points P and Q remain similar to the earlier levels.

Due to the rise in ATC, now ATC > P.

This causes the firm to make losses. The area is shown as the pink rectangle.

Now, the firm cannot raise price easily. P was determined by MC = MR, and it is based on the profit maximizing Q.

The firm has to lower its costs of production in order to be profitable.