Question

You have been hired to advise a monopolist on its pricing and output policy. An independent research firm has estimated its elasticity of demand to be –0.5. Would you recommend that the monopolist change its output? If so, in what direction? Explain your answer and illustrate with an appropriate graph.

Answer 1

Ans:

The monopolist should always choose the price-output combination in the elastic region of the demand curve.

A monopolist wishing to maximise profit produces the output up to that amount at which MC = MR. But it is said that no monopolist will ever fix the output for his product at any level where demand for his product is inelastic (i.e., ep < 1), it would be always possible on the part of a monopolist to increase his total revenue by restricting output (and thereby raising the price).

Since marginal costs are always positive, a reduction in output will reduce total cost. At the same time, since demand is inelastic, i.e., ep < 1, a reduction in output will increase total revenue. Profits will, therefore, continue to rise as output is reduced. So, as long as demand is inelastic, any increase in price through the lowering of output would increase his profits continuously and monopoly equilibrium is not possible.

As at B on the average revenue curve ep=1, the corresponding marginal revenue here will be zero. If price and output were fixed at this stage, both MR and MC ought to be zero, but MC can never be zero. So, at the output intersection of MC1 with x-axis, price and output cannot be fixed because of demand is unitary elastic. Again, if price and output were fixed at the stage where ep<1 (i.e., at intersection of MR and MC2 in the figure), marginal cost must be negative as here marginal revenue is negative.But this is also not possible. It shows that as marginal cost is always positive, monopoly equilibrium is possible only at that stage where demand is elastic.

Thereby, only possible equilibrium is P on MC curve (positive marginal revenue), i.e., in-between points D and B on the average revenue curve because in that region ep>1.