Thus far, our articles exploring marginalism and the firm were written under a snuck premise, namely that the firms were subject to what’s known as perfect competition. This term is exactly what it sounds like: a theoretical framework assuming ideal market conditions. More specifically, it’s characterized by the following:
Many firms in the market, none of which are “large”, relatively speaking
No barriers to entry or exit, meaning firms can move in and out of the market with ease
The firms aren’t selling differentiated products - the goods being sold are homogenous
All firms and consumers have complete information as to the products and its production processes
The validity of these conditions, as you’ve probably noted, are fairly big assumptions from which to then evaluate the marginal costs, revenue, and profits of a firm. Exactly why economists make these assumptions, sometimes by default, is a bit beyond the scope of this article, so we’re going to explore the marginal costs, revenue, and profits of the other extreme end of assumptions: monopolies.
For those of you who haven’t read our monopoly article, just to quickly recap, a monopolistic market structure is characterized by:
Only one firm selling the good or service
High barriers to entry, so high in fact that other firms can’t enter the market. This is how the sole provider of the good or service remains the sole provider
No close substitutes for the good or service (a product or service that consumers see as essentially the same or similar-enough to another product)
This means that unlike firms under perfect competition, monopolies are price makers as opposed to price takers: instead of assuming the market price, the monopoly firm sets the price according to their bidding. To understand the cost curves and marginal revenues/profits of a monopoly, we need to first re-asses some basic firm principles and how they differentiate under monopolies:
Under perfect competition, the demand curve would equal the marginal revenue curve (the red line would be the same as the blue line). Monopolies, being price-makers, are able to sell for very high prices if they so choose but they can’t price discriminate. This is a pricing strategy where the same provider sells identical or largely similar products for different prices.
Why would a firm do this? The key reason lies in appealing to a diverse consumer base. Let’s go back to our coffee shop, as demonstrated in the graph above. If you didn’t engage in any sort of price discrimination, those who aren’t willing to pay $10 for the coffee won’t pay - only those who are willing to pay will do so. Whereas if you decide to engage in price discrimination, you can still receive revenue from those who aren’t willing to pay $10 by instead charging them only $7.
We’ll go more in depth on price discrimination and its feasibility under given market conditions in another article (you actually can have monopolies which engage in price discrimination but let’s not get lost in the weeds here).
So why can’t our monopoly coffee shop price discriminate? Say we have a very wealthy customer named John who’s willing to pay $10 for a cup of coffee, and so he makes the purchase as such. We, the coffee shop owners, have thus far sold 1 unit and gained $10 in revenue.
Let’s redo this situation, but tweak it slightly. We want to sell 2 cups of coffee, and in order to do so we need to charge each cup of coffee at $9. John (the same wealthy man from before) walks in along with another customer: Sam. He’s only willing to pay $9 for the cup of coffee, whereas John is still perfectly fine with paying $10. But John sees that the coffee is selling for $9, so he saves an extra buck.
See what just happened there? John was willing to pay $10, but we charged him only $9 - we didn’t max out his demand, so to speak. This results in an opportunity cost of $1. And these opportunity costs continue to increase the further we go:
Let’s sell the coffee cups at $8 each, thus attracting 3 customers: John, Sam, and Max. John is willing to pay $10 for the coffee, Sam is willing to pay $9, but Max is willing to pay no more than $8. Since we don’t price discriminate, all 3 pay $8, costing us $3.
Notice how when we start selling 7 units for $4 each our MR becomes negative - when the price gets that low, we’re taking a hit on all of the previous units we’re selling, resulting in not only negative marginal revenue, but also lower total revenue.
Being a monopolist is often romanticized as having lots of market power and being able to simply charge sky-high prices with no one being able to do anything about it. As we just have and will continue to see in the next few articles, however, that isn’t necessarily the case. Sometimes being subject to sufficient competition, so that you’re a price taker as opposed to a price maker, simply makes the economics a whole lot easier.