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 summary, when a monopoly's profit-maximizing price is below its average variable cost, the firm should supply no output (0 units) in order to minimize losses. This decision is made to avoid incurring losses from producing goods that do not generate enough revenue to cover the variable costs. The monopoly will either exit the market or wait for an increase in demand or a decrease in variable costs, allowing it to operate profitably again.

Step-by-step solution

Identify the relevant curves

First, we need to understand the relationship between the different curves involved in this problem. There are three relevant curves: demand (D), average variable cost (AVC), and marginal cost (MC).

Draw the graph

In order to find the output the monopoly should supply, we will first draw the graph that represents the relationship between the demand, average variable cost, and marginal cost curves. Draw the three curves with the quantity of output on the horizontal axis and the price on the vertical axis. Make sure to label the axes and curves. You should draw the demand curve with a downward slope (indicating that the higher the price, the lower the quantity demanded) and the marginal cost curve with an upward slope (indicating that the higher the output, the higher the marginal cost of producing it). The average variable cost curve should also have a U-shape and be below the marginal cost curve.

Determine the profit-maximizing output

To find the profit-maximizing output, observe where the marginal cost (MC) curve intersects the demand (D) curve. Under normal circumstances, this point indicates the profit-maximizing output level, as it is where the additional revenue from selling one more unit equals the additional cost of producing one more unit. However, in this case, the exercise states that the profit-maximizing price is below the average variable cost (AVC). Hence, on the graph, the point where the MC curve intersects the D curve will appear below the AVC curve.

Analyze the firm's decision

Since the profit-maximizing price is below the average variable cost, it is not profitable for the firm to operate in the short term. If the firm were to produce the profit-maximizing output, it would incur losses, as the revenue it receives is not sufficient to cover its variable costs. Given this situation, the monopolist should supply no output (zero units) in order to minimize its losses. This decision is supported by the fact that the firm is better off shutting down production and not incurring any variable costs, rather than operating and incurring losses. When firms face this situation, they may decide to exit the market or wait until demand increases or variable costs decrease, allowing them to operate profitably again. In summary, the firm should supply no output (0 units) to minimize losses when its profit-maximizing price is below its average variable cost.

Key concepts

Profit-Maximizing Output

Understanding the concept of profit-maximizing output is vital for any firm, especially a monopoly. This is the level of production at which a firm makes the largest possible profit. In simple terms, it's where the extra cost of making one more unit (marginal cost) is exactly equal to the extra income the firm would acquire from selling that unit (marginal revenue).

To find this point on a graph, a monopoly can look at the intersection of the Marginal Cost (MC) and Marginal Revenue (MR) curves. In perfect competition, the MR curve is the same as the demand curve, but for a monopoly, MR is always below the demand curve due to the downward sloping demand. The profit-maximizing rule for a monopolist is to produce at the quantity where MC equals MR, not the market price.

However, if the demand falls to where the profit-maximizing price is below the Average Variable Cost (AVC), the firm should consider halting production to prevent losses. This is because the revenue generated would not be sufficient to cover variable costs, leading to a scenario known as a 'shutdown point' where the firm is better off not producing at all.

Average Variable Cost

Average Variable Cost (AVC) is the total variable costs (such as labor, raw materials) per unit of output. It's crucial for a business to consider as it fluctuates with changes in the quantity produced. The AVC typically decreases as production increases due to the spreading of fixed costs over more units, but can eventually rise if inefficiencies occur at higher levels of production (due to the law of diminishing returns).

An AVC curve usually takes on a U-shaped graph. A firm's shutdown point occurs at the price and quantity where the market price is equal to the AVC. If the market price falls below the AVC, the firm should shut down production in the short term to avoid incurring further losses. To put it simply, if the price you can sell a product for doesn't cover the variable costs of making it, you're losing money on each item sold.

Marginal Cost

Marginal Cost (MC) is the cost of producing one additional unit of output. It is an essential concept for businesses as it helps in determining the effect on total costs of an increase in production. The MC curve is upward-sloping because as a firm produces more, the costs of producing each additional unit typically increase due to factors like overtime payments for workers or the need for more expensive materials.

For a monopoly, or any other firm, the goal is to align the MC with the MR to maximize profits. Nonetheless, when demand drops significantly, as in the exercise, forcing the MC below the AVC, producing any additional units would only amount to greater losses. At this juncture, businesses need to decide whether to continue production or to stop in hopes of better conditions in the future. Therefore, the MC is a crucial indicator that tells a firm whether it's financially sensible to increase output or scale down.