Profit Maximization: Marginal Revenue and Marginal Cost

1. Monopoly and Efficiency Preview: Monopoly and Perfect Competition Similarity: Motivation Both the monopoly firm and the perfectly competitive firm seek to maximize profit. Difference: Marginal Revenue (MR) Competitive firm: MR = Price Monopoly firm: MR < Price Profit Maximization: Marginal Revenue and Marginal Cost Marginal Revenue (MR): Change in the firm’s total revenue resulting from a one unit change in production. Marginal Cost (MC): Change in the firm’s total cost resulting from a one unit change in production. MR > MC MR = MC MR < MC Profit is maximized Less production increases profit More production increases profit

2. Perfect Competition, Monopoly, and Marginal Revenue Perfectly Competitive Industry Monopoly A large number of small independent firms One large firm A single firm’s production decision does not significantly affect the price.  The monopoly firm decides not only on quantity to produce, but also on the price to charge. A firm can only decide on the quantity of output to produce Preview of Monopoly A firm takes the price as given, as a constant Monopoly produces a quantity and charges a price that lies on the market demand curve. MR curve horizontal: MR = Price Monopoly’s marginal revenue curve lies beneath the market demand curve: MR < Price MR P, MR Price Price MR = Price MR D q Q Quantity

3. Monopoly and the Market Demand Curve P ($ per computer) Demand Curve for Personal Computers in 1980 Claim: A profit maximizing monopoly produces a quantity 3,500 and charges a price 3,000 that lies on the market demand curve. 2,500 Suppose that Apple produced 500 computers per day. 2,000 D Claim: Apple would charge a price of $3,000. Q 250 500 750 1,000 (Computers per day) Suppose that Apple continued to charge a price of $3,000, but produced 750 computers per day. Suppose that the firm reduced production without changing the price. Profit = Total Revenue  Total Cost Unaffected Decreased Increased A monopoly would never produce a quantity and charge a price above the demand curve. Suppose that Apple continued to produce 500 computers per day, but charged a price of $2,000. Suppose that the firm raised the price without changing production. Profit = Total Revenue  Total Cost Increased Increased Unaffected A monopoly would never produce a quantity and charge a price below the demand curve.

4. Monopoly and the Market Demand Curve P ($ per computer) A profit maximizing monopoly Slope = 2 produces a quantity 3,500 and charges a price 3,000 that lies on the market demand curve. Marginal Revenue (MR):Change in the firm’s total revenue resulting from a one unit change in production. 2,500 2,000 D What is the slope of the demand curve? Q 250 500 750 1,000 Rise 1,000 Slope = =  = 2 (Computers per day) Run 500 Suppose that Apple produced 500 computers per day. $3,000 What price would Apple charge? What is Apple’s marginal revenue (MR)? What price would Apple now charge? Quantity Price Total Revenue = Price  Quantity Oct 3 501 2,998 2,998501 = 1,501,998 $2,998 Oct 2 500 3,000 3,000500 = 1,500,000 Marginal Revenue = 1,998

5. Monopoly and the Market Demand Curve P ($ per computer) A profit maximizing monopoly will always Slope of demand curve = 2 3,500 produce a quantity and charge a price 3,000 that lies on the market demand curve. 2,500 Marginal Revenue (MR):Change in the firm’s total revenue resulting from a one unit change in production. 1,000 2,000 D Q 250 500 750 1,000 Quantity Price Total Revenue = Price  Quantity (Computers per day) Oct 3 501 2,998 2,998501 2,998(1 +500) = 2,998 + 2,998500 Oct 2 500 3,000 3,000500 = 3,000500 Marginal Revenue = 2,998 + 2,998500  3,000500 NB: As a consequence of the price effect marginal revenue for a monopoly is less than the price. = 2,998 + (2,998  3,000)500 = 2,998 + (2)500 Output Effect: TR tends to increase by $2,998, the price. Price Effect: TR tends to decrease by $1,000 because the price must be reduce to sell the additional unit Monopoly:MR < Price Marginal Revenue = 2,998  1,000 = 1,998

6. Monopoly and the Market Demand Curve P ($ per computer) A profit maximizing monopoly 3,500 MC produces a quantity and charges a price P* = 3,000 3,000 that lies on the market demand curve. 2,500 2,000 D Question: How many computer will Apple produce? MR Q 250 500 750 1,000 Answer: The profit maximizing quantity. Q* = 500 (Computers per day) MR = MC When Q = 500 P = 3,000 Q* = 500 Monopoly:MR < Price MR < 3,000 Question: What price will Apple charge? The marginal revenue curve for a monopoly lies below the market demand curve. P* = 3,000

7. Summary : Perfect Competition, Monopoly, and Profit Maximization Perfect Competition Monopoly  A single firm’s production decisions cannot affect the price significantly  The monopoly firm decides not only on quantity to produce, but also on the price to charge.  MR = PriceorPrice = MR  MR < PriceorPrice > MR Profit Maximization  MR = MC Price = MR = MC Price > MR = MC  Price = MC  Price > MC

8. Wall Street Journal May 26, 2010, 9:03 AM ET Getting to Know You: Apple and the Government’s Trustbusters By Ashby Jones Once upon a time, like 10 years ago, Apple was the scrappy underdog of the computer world. That’s all. It made computers fringed in colors like tangerine and blueberry which crashed from time to time, just like all the others. . . . But then came a new operating system, a stream of better computers, and all the “i’s” — the iPod, the iPhone, iTunes, etc., etc., etc. Ten years later, Apple’s a top dog, and top dogs get hard looks from antitrust regulators. . . . And that brings us to this story in Wednesday’s New York Times. According to the piece, antitrust lawyers in the Justice Department are examining Apple’s tactics … Question: Why is “big,” “bad” and “small,” “good? ”

9. Lesson of American-US Airways Merger: Don’t Mess With Washington By Tom Gara Wall Street Journal August 13, 2013 The Department of Justice’s lengthy complaint against the merger of American Airlines and U.S. Airways runs through a solid list or worries about the deal. . . . Passengers to and from the Washington, D.C. area are likely to be particularly hurt. To serve Ronald Reagan Washington National Airport (“Reagan National”), a carrier must have “slots,” which are government-issued rights to take off and land. . . . The combined airline would have a monopoly on 63% of the nonstop routes served out of the airport. . . . Question: Why is monopoly “bad?”

10. What’s bad about monopoly? P ATC Monopolies exploit the public by earning obscenely high profits? MC ATC Monopoly: MR curve lies below the demand curve Profit maximization: MR = MC P* Monopoly: P and Q lie on the demand curve. Question: Can we determine the monopoly’s profit? Answer: No, we need the ATC curve D Could the monopoly be earning positive profit? Could the monopoly be earning negative profit? MR P > ATC P <ATC Profit < 0 Profit > 0 Q Q* Pareto’s Efficiency Question: Are we getting the most from our economy’s finite resources? Pareto’s Query: Given the state of affairs in question, is it possible to make one individual better off without hurting anyone else? Yes No  Is the state of affairs getting the most from the economy’s resources?  Is the state of affairs getting the most from the economy’s resources? No Yes  State of affairs is inefficient.  State of affairs is efficient.

11. Price ($ per hamburger) How many hamburgers will Mary produce? 50 Profit maximization: MR = MC 2.00 MC What price will she charge? $1.50 Monopoly: P and Q on the demand curve. $1.00 What does her marginal cost equal? 1.50 1.50 State of Affairs Q = 50 P = 1.50 MC = 1.00 Question: Is this state of affairs efficient? 1.00 1.00 Joe: Does not buy a hamburger at the profit maximizing price of $1.50, but would buy a hamburger if the price were $1.40. .50 How do we know that a person like Joe exists? The demand curve is downward sloping. MR D Quantity (hamburgers) 50 200 50 100 150 Special Deal: Mary produces another hamburger and sells it to Joe for $1.30. Question: Would the special deal make Joe better off? Question: Would the special deal make Mary better off? Yes Yes Question: Would the special deal affect anyone else? Profit = Total Revenue  Total Cost No Up .30 Up 1.30 Up 1.00 Pareto’s Query: Given the state of affairs in question, is it possible to make at least one individual better off without hurting anyone else? Yes: Inefficient No: Efficient

13. Pareto’s Efficiency Question: Are we getting the most from our economy’s finite resources? Pareto’s Query: Given the state of affairs in question, is it possible to make one individual better off without hurting anyone else? Yes No  Is the state of affairs getting the most from the economy’s resources?  Is the state of affairs getting the most from the economy’s resources? No Yes  State of affairs is inefficient.  State of affairs is efficient.

14. U.S. Moves to Block Big Air Merger Antitrust Regulators Say American-US Airways Deal Would Hurt Consumers By Susan Carey, Brent Kendall, and Jack Nicas Wall Street Journal August 13, 2013 The Justice Department unexpectedly moved to block the merger of American Airlines parent AMR Corp. and US Airways Group Inc., threatening to upend what was viewed as the final step in the consolidation that has helped return U.S. airlines to profit after years of heavy losses. The department's legal challenge to the deal also could throw a wrench into AMR's plans to quickly emerge from bankruptcy-court protection, as the merger is the basis of its bankruptcy-exit plan. The two airlines had hoped for Washington's blessing ahead of a bankruptcy-court hearing set for Thursday to confirm the exit plan, which has the support of the company's creditors and unions. . . . "This transaction would result in consumers paying the price—in higher airfares, higher fees and fewer choices," U.S. Attorney General Eric Holder said in a statement. . . .

15. Wall Street Journal July 12, 2010, 10:51 AM ET In San Jose, an Antitrust Case Against Apple Moves Forward By Ashby Jones It’s almost axiomatic at this point: the larger, wealthier and more powerful a company grows, the more its products enter the stream of commerce and, in turn, the more it becomes viewed as a deep pocket. In short, the larger a company grows, the more it’s forced to contend with lawsuits. It’s happened in the tech sector for years (think Google and Microsoft and, years ago, IBM). And now it’s happening to Apple. Last Thursday, the company (among others) was sued by patent holding company NTP; NTP claims Apple is infringing patented technology that connects cellphones to email. That same day, a federal judge in San Jose, Calif., certified a class of all iPhone purchasers in an antitrust suit against Apple and AT&T Mobility. … The suit, which alleges monopolistic behavior, consolidates several filed by iPhone buyers starting in late 2007, a few months after Apple’s iPhone went on sale. A 2008 amended complaint alleges that that Apple and AT&T conspired to monopolize the voice and data services by forcing class members to use AT&T’s service and denying them the ability to switch carriers. The lawsuit also says Apple secretly made AT&T its exclusive US iPhone partner for five years. The suit says consumers agree to two-year contracts but are in effect locked into a five-year relationship with AT&T. Question: Why is “big” (monopoly) “bad” and “small” (perfect competition) “good”?