Question

When does a monopolist make a short-run economic profit? When does it make short-run economic loss, but continue production? When does it shut down?

Answer 1

Before answering this question we need to understand the difference between short run and long run.

In short run when firm stops production it is said to be shut down because fixed costs are sunk cost in short run and cannot be recovered. But in long run when firm stops production then it is said that firm exits the market since the fixed costs can be recovered in long run so firm chooses to exit rather then just shutting down in the long run.

Now let's come to question.

The monopoly will make profit in the short run if the, price is greater than the average cost of production.

Profit = revenue - total cost

Profit = P×Q - TC

Here P= price of good monopoly produces

Q= quantity of output monopoly produces

We can write Total cost TC = TC/Q × Q and total cost divided by the quantity is average cost. So,

TC = Q× AC

Putting this into our profit function we get,

Profit = Q(P - AC)

As you can monopoly will only make positive profits if the price is greater than average cost AC.

So monopoly will only make profit it the price is greater than the average cost of production or P > AC.

When will the monopoly be making loses but still choosing to produce?

As we discussed earlier that fixed cost are sunk cost in the short run and they can't be recovered in short run.

Monopoly will choose to produce even if he is making a loss if the price is greater than average variable cost but less than average cost of production. Because what monopolist is concerned about in short run is average variable cost of production. So as long as firm is being able to earn the average variable cost of production in short run it will be happy to produce in short while making looses.

For example let's suppose,

Average cost of production = 10

Average variable cost of production = 5

Price = 8

And monopoly is producing 10 units of good.

Here the profit of the monopolistic will be,

Profit = Q(P - AC)

Profit = 10(8 - 10)

Profit = 10(-2) = -20

As you see here profit is negative which means monopolist is making a loss.

Variable cost of production = AVC × Q

Variable cost of production = 5×10 = 50

So the variable cost of production is 50. Now let's calculate the revenue for the monopolist,

Revenue = P × Q

Revenue = 8 × 10 = 80

As you can see that revenue is greater than the variable cost of production. So firm is not losing anything by producing.

But as discussed earlier fixed costs are sunk costs, so what monopolist looks at is average variable cost of production rather than average cost of production in shorg run because it's average variable cost that firm is additionally paying for production so as long as monopolist can earn more than the average variable cost of production he will choose to produce even when he is making a loss.

The condition under which monopoly will make loses but continue production is price is greater than average variable cost but less than average cost of production,

AVC < P < AC.

And now when the monopoly will choose to shut down production?

As we have discussed monopoly will choose to produce even if it is making loses only if the price is greater than average variable cost but when the price is below the average variable cost them monopoly has no other choice but to shut down production.

As discussed earlier fixed costs are sunk costs but if the monopoly is not able earn variable cost of production then it will choose to shut down because if it doesn't and chooses to keep producing then it will make additionally loses which is not what monopolist wants.

So the condition under which monopoly will shut down is price is less than average variable cost, P < AVC.