Profit Maximization
In traditional economics, the goal of a firm is to maximize their profits. This means they want to maximize the difference between their earnings, i.e. revenue, and their spending, i.e. costs. To find the profit maximizing point, firms look at marginal revenue (MR) - the total additional revenue from selling one additional unit of output - and the marginal cost (MC) - the total additional cost of producing one additional unit of output. When the marginal revenue of selling a good is greater than the marginal cost of producing it, firms are making a profit on that product. This leads directly into the marginal decision rule, which dictates that a given good should continue to be produced if the marginal revenue of one unit is greater than its marginal cost. Therefore, the maximizing solution involves setting marginal revenue equal to marginal cost.
This is relatively straightforward for firms in perfectly competitive markets, in which marginal revenue is the same as price . Monopoly production, however, is complicated by the fact that monopolies have demand curves and MR curves that are distinct, causing price to differ from marginal revenue .
Monopoly
In a monopoly market, the marginal revenue curve and the demand curve are distinct and downward-sloping. Production occurs where marginal cost and marginal revenue intersect.
Perfect Competition
In a perfectly competitive market, the marginal revenue curve is horizontal and equal to demand, or price. Production occurs where marginal cost and marginal revenue intersect.
Monopoly Profit Maximization
The marginal cost curves faced by monopolies are similar to those faced by perfectly competitive firms. Most will have low marginal costs at low levels of production, reflecting the fact that firms can take advantage of efficiency opportunities as they begin to grow. Marginal costs get higher as output increases. For example, a pizza restaurant can easily double production from one pizza per hour to two without hiring additional employees or buying more sophisticated equipment. When production reaches 50 pizzas per hour, however, it may be difficult to grow without investing a lot of money in more skilled employees or more high-tech ovens. This trend is reflected in the upward-sloping portion of the marginal cost curve.
The marginal revenue curve for monopolies, however, is quite different than the marginal revenue curve for competitive firms. While competitive firms experience marginal revenue that is equal to price - represented graphically by a horizontal line - monopolies have downward-sloping marginal revenue curves that are different than the good's price.