Computing Monopoly Profits

It is straightforward to calculate profits of given numbers for total revenue and total cost. However, the size of monopoly profits can also be illustrated graphically with Figure 1, which takes the marginal cost and marginal revenue curves from the previous exhibit and adds an average cost curve and the monopolist’s perceived demand curve.

Figure 1. Illustrating Profits at the HealthPill Monopoly. This figure begins with the same marginal revenue and marginal cost curves from the HealthPill monopoly from the previous page. It then adds an average cost curve and the demand curve that the monopolist faces. The HealthPill firm first chooses the quantity where MR = MC. In this example, the quantity is 5. The monopolist then decides what price to charge by looking at the demand curve it faces. For a quantity of 5, the corresponding price on the demand curve is $800. The large box, with quantity on the horizontal axis and demand (which shows the price) on the vertical axis, shows total revenue for the firm. The lighter-shaded box, which is quantity on the horizontal axis and average cost of production on the vertical axis shows the firm’s total costs. The large total revenue box minus the smaller total cost box leaves the darkly shaded box that shows total profits. Since the price charged is above average cost, the firm is earning positive profits.

The three-step process where a monopolist selects the profit-maximizing quantity to produce, decides what price to charge, and then determines total revenue, total cost and profit. These steps include:

Step 1: The Monopolist Determines Its Profit-Maximizing Level of Output

Since each point on a demand curve shows price and quantity, the firm can use the points on the demand curve D to calculate total revenue, and then, based on total revenue, calculate its marginal revenue curve. The profit-maximizing quantity will occur where MR = MC—or at the last possible point before marginal costs start exceeding marginal revenue. On Figure 1, MR = MC occurs at an output of 5.

Step 2: The Monopolist Decides What Price to Charge

The monopolist will charge what the market is willing to pay. A dotted line drawn straight up from the profit-maximizing quantity to the demand curve shows the profit-maximizing price which, in Figure 1, is $800. This price is above the average cost curve, which shows that the firm is earning profits.

Step 3: Calculate Total Revenue, Total Cost, and Profit

Total revenue is the overall shaded box, where the width of the box is the quantity sold and the height is the price. In Figure 1, this is 5 x $800 = $4000. The bottom part of the shaded box, which is shaded more lightly, shows total costs; that is, quantity on the horizontal axis multiplied by average cost on the vertical axis or 5 x $330 = $1650. The larger box of total revenues minus the smaller box of total costs will equal profits, which the darkly shaded box shows. Using the numbers gives $4000 – $1650 = $2350. In a perfectly competitive market, the forces of entry would erode this profit in the long run. However, a monopolist is protected by barriers to entry. In fact, one obvious sign of a possible monopoly is when a firm earns profits year after year, while doing more or less the same thing, without ever seeing increased competition eroding those profits. 

Figure 2. How a Profit-Maximizing Monopoly Decides Price. In Step 1, the monopoly chooses the profit-maximizing level of output Q₁, by choosing the quantity where MR = MC. In Step 2, the monopoly decides how much to charge for output level Q₁ by drawing a line straight up from Q₁ to point R on its perceived demand curve. Thus, the monopoly will charge a price (P₁). In Step 3, the monopoly identifies its profit. Total revenue will be Q₁ multiplied by P₁. Total cost will be Q₁ multiplied by the average cost of producing Q₁, which point S shows on the average cost curve to be P₂. Profits will be the total revenue rectangle minus the total cost rectangle, which the shaded zone in the figure shows.

In a perfectly competitive market, the forces of entry would erode this profit in the long run. But a monopolist is protected by barriers to entry. In fact, one telltale sign of a possible monopoly is when a firm earns profits year after year, while doing more or less the same thing, without ever seeing those profits eroded by increased competition.