Question

Suppose demand for a monopoly's product falls so that its profit-maximizing price is below average variable cost. How much output should the firm supply? Hint: Draw the graph.

Short answer

In the given scenario, the profit-maximizing price is below the average variable cost (AVC). Under these circumstances, the monopoly should supply zero output in the short run to minimize its losses. By doing so, the firm avoids incurring extra variable costs which could result in even larger losses. Hence, the amount of output that the monopoly should supply is zero.

Step-by-step solution

1. Overview of Monopoly and Profit Maximization

A monopoly is a market structure where a single firm controls the whole industry and is the sole provider of a product or service. In a monopoly, the firm's objective is to maximize profit. Profit maximization occurs where marginal revenue (MR) equals marginal cost (MC). To find this level of output, we need to understand the demand curve and marginal cost curve for the monopoly.

2. Draw the Graph

First, start by plotting the demand curve, which represents the relationship between the quantity demanded and the price of the product. Since we know that the profit-maximizing price is below average variable cost, the demand curve should be downward sloping. Next, draw the marginal cost curve, which shows the additional cost per unit of output produced. The MC curve is typically upward-sloping, meaning that as output increases, the cost per additional unit also increases. Finally, we need to draw the average variable cost curve (AVC). The AVC curve represents the average cost of producing each extra unit of output. It is the total variable cost of production divided by the quantity produced. Typically, the AVC curve is U-shaped, with costs initially decreasing as output increases and then increasing after reaching the minimum point. Remember to label the axes (quantity on the horizontal axis and cost/price on the vertical axis) and the intersection points of the various curves.

3. Find the Profit-Maximizing Output Level

Now, we need to find the output level where the monopoly can maximize its profit. This occurs at the intersection of the marginal revenue and marginal cost curves (MR = MC). Locate this intersection point on the graph.

4. Determine the Corresponding Price

At the profit-maximizing output level, identify the corresponding price on the demand curve. Since we are told that this price is below the average variable cost, it confirms that the intersection point of MR and MC should be positioned below the AVC curve.

5. Determine the Optimal Output Level If Price Is Below AVC

In this situation, when the profit-maximizing price is below the average variable cost, it implies that the monopolist is not able to cover its variable cost of production. Under these circumstances, the monopoly should supply zero output in the short run to minimize its losses. By doing so, the firm avoids incurring extra variable costs which could result in even larger losses. Therefore, in this scenario, the amount of output that the monopoly should supply is zero since the profit-maximization point occurs at a price below the average variable cost.