Question

Describe how firms with market power decide how much to produce in order to maximise profit. Comment on the efficiency of this output.

Answer 1

For a firm with market power, like for instance a monopolist firm, needs to maximize its profits if it wants to retain the market power it has now. So how do they do it anyways? For this first let's take a gander at the demand graph for a monopolist as shown below.

Like any other firm, profits are nothing but the total revenue minus the total costs. The answer to maximize the same lies in the analysis of marginal cost and marginal revenue. In case that the latter exceeds the former, then it is wise for the firm to produce goods and the profit maximization occurs at MR = MC. As you might have seen from the graph, it looks very similar to a normal market demand curve. Hence the challenge here is to identify the right quantity and price for maximizing the profits. Setting a high price means the quantity demanded is low thus profits decrease. On the other hand, setting a low price means the quantity demanded is high but due to the low prices the profits once again low. Hence an intermediate combination of price and quantity needs to be achieved for maximizing profits.

The efficiency of this process is optimal, else firms won't consider this as a profit maximizing condition in the first place. To give more relevance to this, let's analyze the total cost and total revenue curves for a typical monopolist as shown below.

The profits are highest when the total revenue is farthest above total cost, or in simple their difference is the highest. This is where we can conclude a maximizing condition is achieved for efficiency.

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