Question

Draw a demand curve and the corresponding marginal-revenue curve for a firm selling in a monopoly and another firm selling in perfect competition. Explain which demand curve is the most elastic. What does this mean for the marginalrevenue curve?

Short answer

Answer: The demand curve for a perfectly competitive market is more elastic than that for a monopoly market. The elasticity of the demand curve affects the marginal revenue curve. In perfect competition, the marginal revenue curve coincides with the demand curve due to the perfectly elastic demand, while in a monopoly market, the marginal revenue curve lies below the demand curve as the monopolist needs to decrease prices to sell additional units.

Step-by-step solution

Draw the Demand Curve for a Monopoly Market

To draw the demand curve for a monopoly market, remember that the monopolist faces the entire market demand curve, which is typically downward-sloping. The monopolist can set the price for its product due to the absence of competition.

Draw the Marginal Revenue Curve for a Monopoly Market

The marginal revenue curve for a monopolist lies below the demand curve. The reason is that the monopolist has to reduce the price on all units sold to sell an additional unit, causing the marginal revenue to be lower than the price of the good.

Draw the Demand Curve for a Perfectly Competitive Market

In a perfectly competitive market, each firm faces a horizontal or perfectly elastic demand curve at the market price. This indicates that the firm can sell any quantity of the product at the market price without affecting the price.

Draw the Marginal Revenue Curve for a Perfectly Competitive Market

In perfect competition, the marginal revenue curve coincides with the demand curve. This is because the firm can sell an additional unit at the market price without affecting the overall price, so the marginal revenue is equal to the market price.

Compare the Elasticity of the Two Demand Curves

The demand curve for a perfectly competitive market is more elastic (perfectly elastic) than that for a monopoly market. This means that the competitive firm faces a higher level of price sensitivity from consumers.

Discuss the Implications of Elasticity on Marginal Revenue Curves

The elasticity of the demand curve has implications on the marginal revenue curve. In perfect competition, since the demand curve is perfectly elastic, the marginal revenue curve coincides with the demand curve. In contrast, for a monopoly where the demand curve is less elastic, the marginal revenue curve lies below the demand curve due to the monopolist's need to decrease prices to sell additional units. In conclusion, more elastic demand curves result in a marginal revenue curve that is closer to the demand curve.

Key concepts

Marginal Revenue Curve

Understanding the marginal revenue (MR) curve is crucial in economics because it represents the change in total revenue that arises from selling an additional unit of output. It is a fundamental concept for any business when deciding how much product to supply at a given price.
In a monopoly market, the MR curve is downward sloping and lies below the demand curve. Why does this happen? A monopolist must reduce the price of all units sold to sell one more unit, consequently, each additional unit sold increases total revenue by less than the price at which the unit is sold. In mathematical terms, the MR can be calculated using the formula
\(MR = \frac{\text{{Change in Total Revenue}}}{\text{{Change in Quantity Sold}}}\).
As the output increases, the MR decreases due to the price effect of having to lower prices to encourage more sales, which is a characteristic feature of monopoly markets.

• The MR curve helps a monopolist determine the profit-maximizing level of output.
• Since the MR is lower than the price, it will always fall faster than the demand curve.

For perfectly competitive firms, the MR curve is different. These firms are price takers, meaning they can sell infinite amounts of their product at the market price. Thus, their MR curve is a horizontal line at the market price level, indicating that the MR of selling one extra unit is equal to the market price, which remains constant regardless of the quantity sold. This difference in the shapes of MR curves between monopoly and perfect competition markets has profound implications for market behavior and strategy.

Monopoly Market

A monopoly market is characterized by a single seller, and thus it represents the entire market for a particular good or service. This exclusive position allows the monopolist to wield considerable power over the price and quantity of the product offered.
What sets a monopolistic market apart from a competitive one is the lack of close substitutes for the product offered, resulting in the absence of competition. Here's why this matters:

• Consumers in a monopoly market have fewer choices and may need to accept higher prices or lower quality.
• Monopolists can influence prices due to the downward sloping demand curve they face, unlike perfectly competitive markets where the demand curve is horizontal at the market price.
• The monopolist's demand curve is not perfectly elastic because consumers do not have perfect substitutes; thus, they have some flexibility in setting prices above the marginal cost.

Ultimately, the monopolist seeks to maximize profits by deciding the optimal level of output where marginal revenue equals marginal cost (MR = MC). At this point, the additional revenue from selling one more unit equals the additional cost of producing it. Any deviation from this output level could potentially mean missed opportunities for profits.

Perfect Competition

Perfect competition represents an idealized market structure that provides a benchmark against which to compare real-world markets. The characteristics defining a perfectly competitive market include a large number of small firms, identical products offered by each firm, no barriers to entry or exit, and perfect knowledge by all participants.
Highlighted features of perfect competition are:

• Firms in a perfectly competitive market are price takers, meaning the market sets the price and firms have no control over it.
• The demand curve a perfectly competitive firm faces is perfectly elastic; it can sell as much as it wants at the market price but nothing at a higher price.
• In the long run, firms in a perfectly competitive market earn normal profits, which are zero economic profits, due to the freedom of entry and exit.

Under perfect competition, the marginal revenue that a firm receives from selling an additional unit is constant and equals the market price. This results in the MR curve being identical to the demand curve, which is a horizontal line at the market price. This simplicity helps understand why a perfectly competitive firm would continue to produce until its marginal cost (MC) is equal to the market price (P), ensuring maximum profitability. If the MC is below P, it's beneficial to increase output; if MC is above P, the firm should decrease output.