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Analysis of Market

Equilibrium in Monopoly

The conditions for Equilibrium in Monopoly are the same as those under perfect competition. The marginal cost (MC) is equal to the marginal revenue (MR) and the MC curve cuts the MR curve from below. In this article, we will understand Equilibrium in Monopoly in detail.

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A Firm’s Short-Run Equilibrium in Monopoly

Like in perfect competition, there are three possibilities for a firm’s Equilibrium in Monopoly. These are:

  1. The firm earns normal profits – If the average cost = the average revenue
  2. It earns super-normal profits – If the average cost < the average revenue
  3. It incurs losses – If the average cost > the average revenue

Normal Profits

A firm earns normal profits when the average cost of production is equal to the average revenue for the corresponding output.

Equilibrium in Monopoly

In the figure above, you can see that the MC curve cuts the MR curve at the equilibrium point E. Also, the AC curve touches the AR curve at a point corresponding to the same point. Therefore, the firm earns normal profits.

Super-normal Profits

A firm earns super-normal profits when the average cost of production is less than the average revenue for the corresponding output.

Equilibrium in Monopoly

In the figure above, you can see that the price per unit = OP = QA. Also, the cost per unit = OP’. Therefore, the firm is earning more and incurring a lesser cost. In this case, the per unit profit is

OP – OP’ = PP’

Also, the total profit earned by the monopolist is PP’BA.

Losses

A firm earns losses when the average cost of production is higher than the average revenue for the corresponding output.

Equilibrium in Monopoly

In the figure above, you can see that the average cost curve lies above the average revenue curve for the same quantity. The average revenue = OP and the average cost = OP’. Therefore, the firm is incurring an average loss of PP’ and the total loss is PP’BA. In the short-run, a monopolist sometimes sets a lower price and incurs losses to keep new firms away.

Summary of Short-run Equilibrium in Monopoly

In the short-run, a monopolist firm cannot vary all its factors of production as its cost curves are similar to a firm operating in perfect competition. Also, in the short-run, a monopolist might incur losses but will shut down only if the losses exceed its fixed costs. Further, if the demand for his product is high, then the monopolist can also make super-normal profits.

Equilibrium in Monopoly

The figure shown above depicts a firm’s short-run Equilibrium in Monopoly. The quantity is along the X-axis and price and cost of production along the Y-axis.

There are three curves – the average variable cost (AVC) curve, the average total cost (ATC) curve, and the marginal cost (MC) curve. Further, there are three demand curves to explain the possible positions of the equilibrium:

Demand Curve D1 is tangent to the AVC curve at point E1

Its corresponding MC curve intersects the MR1 curve from below at point A1. Therefore, while the monopolist satisfies the first condition of equilibrium, he is unable to recover his complete cost of production.

However, even if he closes the plant down, he cannot reduce the losses since they are fixed costs.

Therefore, he decides to produce – OM1 quantity of output and sells it at a price E1M1. This ensures that he suffers a loss which is equal to his fixed costs.

It is important to note that if the demand curve lies left to the position of D1, then there is no production since the monopolist would simply add to his losses by operating the plant. In such cases, a monopolist would close down the plan and restrict his losses to the fixed costs.

Demand curve D2

If the demand curve lies to the right of D1, then the monopolist can recover a part of his fixed costs. Further, if this demand curve is tangent to the ATC curve (demand curve D2), then the monopolist can also recover his complete cost of production.

If D2 is the demand curve, then the equilibrium position of the monopolist is at the intersection of the MC curve and the MR2 curve at point A2. This corresponds with the point of tangency between D2 and the ATC curve (point E2).

Therefore, the MC curve cuts the MR2 curve from below and AR = ATC. Hence, the monopolist earns normal profits by producing a quantity OM2 and selling it at a price E2M2.

Demand Curve D3

If the demand curve lies further to the right of D2 (like D3), the monopolist can earn super-normal profits. The equilibrium position is the point of intersection between the MC curve and the MR3 curve at point A3. Therefore, the monopolist produces a quantity OM3 and sells it at a price E3M3.

A Firm’s Long-run Equilibrium in Monopoly

In the long-run, a monopolist can vary all the inputs. Therefore, to determine the equilibrium of the firm, we need only two cost curves – the AC and the MC. Further, since the monopolist exits the market if he is operating at a loss, the demand curve must be tangent to the AC curve or lie to the right and intersect it twice.

Equilibrium in Monopoly

As you can see above, there are two alternative cases for the determination of Equilibrium in Monopoly:

  • With normal profits
  • With super-normal profits

We have not taken the loss scenario here because if the monopolist incurs losses in the long-run, he will stop operating.

Case 1

The demand curve AR1 is tangent to AC or LAC at point E. Remember, if the demand curve lies to the left of the AC curve, then the monopolist is unable to recover his costs and closes down.

However, if the AR curve is tangent to the AC curve, then the monopolist can recover his costs and stay in the market.

Further, note that the perpendicular drawn from point E to the X-axis, the MC curve, and the MR curve are concurrent at point A.

Therefore, all the conditions of equilibrium are satisfied. The monopolist produces OM quantity and sells it at a price of EM per unit which covers its average costs + normal profits.

Case 2

The marginal revenue curve MR2 cuts the MC curve from below at point B. The corresponding height of the AR2 curve is E’M1.

Hence, the monopolist produces OM1 quantity and sells it at E’M1 per unit to earn an extra profit of E’B per unit. Being a monopoly, this extra profit is not lost to competition or newer firms entering the industry.

Solved Question on Equilibrium in Monopoly

Q1. What are the three possibilities for a firm’s Equilibrium in Monopoly?

Answer: The three possibilities are:

  1. The average cost = the average revenue: the firm earns normal profits.
  2. The average cost < the average revenue: the firm earns super-normal profits
  3. Or, the average cost > the average revenue: the firm incurs losses
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