Question

1) (a)What does a monopolist have to do to increase sales? (b) Why does he take that action?

2) (a) When does a firm maximize its profits?
(b) When should a firm “shut down” in the short-run?

Answer 1

1. a For a seller in a purely competitive market, the demand curve is completely elastic, and, therefore, horizontal in a price-quantity graph. A competitive seller can sell as much as he wants at the market price. However, the demand curve for all sellers in the market is downward sloping where demand quantity increases as prices decrease. For a pure monopolist, its supply is the entire market supply, and, thus, downward sloping. Since a monopoly is a price maker, it will determine what quantity of output will yield the greatest profits. But first, let us see how revenue is maximized. In trying to maximize revenue, the monopolist has a dilemma: the monopolist can only sell more product if it lowers its prices,

b. The monopolist has to take this action because it's demand curve slopes downward as demand curves generally do. Demand only increases with decreasing prices, but the marginal revenue gained by selling one additional unit will always be less than the price of that unit because the monopolist will have to sell all its units at the lower price.

This is in contrast to the competitive market, where the competitive firm can sell all that it wants for the market price. Therefore, its marginal revenue = marginal price = market price. As the monopolist increases production, marginal revenue continually declines until it actually becomes negative. At this point, the monopolist is earning the maximum total revenue. More production after that point will cause total revenue to decline.

2. a. In economics, profit maximization is the short run or long run process by which a firm may determine the price, input, and output levels that lead to the greatest profit. Neoclassical economics, currently the mainstream approach to microeconomics, usually models the firm as maximizing profit.

For a firm in a perfectly competitive market for its output, the revenue function will simply equal the market price times the quantity produced and sold, whereas for a monopolist, which chooses its level of output simultaneously with its selling price, the revenue function takes into account the fact that higher levels of output require a lower price in order to be sold. An analogous feature holds for the input markets: in a perfectly competitive input market the firm's cost of the input is simply the amount purchased for use in production times the market-determined unit input cost, whereas a monopsonist’s input price per unit is higher for higher amounts of the input purchased.

The principal difference between short-run and long-run profit maximization is that in the long run the quantities of all inputs, including physical capital, are choice variables, while in the short run the amount of capital is predetermined by past investment decisions. In either case there are inputs of labor and raw materials. A firm maximizes profit by operating where marginal revenue equals marginal cost. In the short run, a change in fixed costs has no effect on the profit maximizing output or price. The firm merely treats short term fixed costs as sunk costs and continues to operate as before.

b. A firm will choose to implement a shutdown of production when the revenue received from the sale of the goods or services produced cannot even cover the variable costs of production. In that situation, the firm will experience a higher loss when it produces, compared to not producing at all.

Technically, shutdown occurs if average revenue is below average variable cost at the profit-maximizing positive level of output. Producing anything would not generate enough revenue to offset the associated variable costs; producing some output would add further costs in excess of revenues to the costs inevitably being incurred. By not producing, the firm loses only the fixed costs.

The goal of a firm is to maximize profits or minimize losses. The firm can achieve this goal by following two rules. First, the firm should operate, if at all, at the level of output where marginal revenue equals marginal cost. Second, the firm should shut down rather than operate if it can reduce losses by doing so.