Competing for customers through the Bertrand model

174 Part III: Market Structures and the Decision-Making Environment

Minimizing losses to make the best of a bad situation

In the short run, monopolies can incur economic losses. In the case of economic losses, the price associated with the marginal revenue equals marginal cost output level is less than average total cost. Figure 10-4 indicates a situation where the monopoly earns negative economic profit.

Figure 10-4:

Producing with economic losses.

In Figure 10-4, note the monopolist’s demand and marginal revenue curves have the same shape as in situations I describe earlier in this chapter. The demand curve is downward-sloping, indicating that the monopolist must lower price to sell a greater quantity of output, and marginal revenue lies below the demand curve. Average total cost, average variable cost, and marginal cost all have the usual shapes. Marginal cost is upward-sloping, reflecting diminishing returns. Average variable cost and average total cost are both U-shaped, and marginal cost passes through the minimum point on both curves.

Given its demand curve and cost curves, this monopolist maximizes profits — minimizes losses — by producing the quantity of output q0 that corresponds to the intersection of marginal revenue and marginal cost. Price is determined by going from q0 up to the demand curve and across to P0.

Economists use the term maximize profits even when they’re minimizing losses. Maximizing profits means the highest possible profit. In the case of a firm that loses money, the highest possible profit is the smallest loss.

Chapter 10: Monopoly: Decision-Making Without Rivals

The firm’s economic loss equals the difference between price and average total cost. It’s a loss because price is less than average total cost, so

The loss per unit is represented by the double-headed arrow labeled –π/q in Figure 10-4.

175

Shutting down

In the short run, if you immediately shut down, you still lose money because of your fixed costs. Shutting down means you produce zero output, earn zero revenue, and incur zero variable costs. However, because you can’t change your fixed inputs, you still have fixed costs. Thus, your short-run losses equal total fixed cost.

In order for an immediate shutdown to make sense, the shutdown has to maximize profits, or, in this case, minimize losses. For that to happen, the economic losses resulting from the production of the output level associated with marginal revenue equals marginal cost are greater than total fixed costs. This is the case if the price determined off the demand curve is less than your average variable cost. Thus, you should immediately shut down if the profit-maximizing price is less than average variable cost. If price is less than average variable cost, you not only lose fixed costs, you’re not even able to pay all your variable costs.

Anticipating the Long Run

The long run allows you to change any input — fixed inputs don’t exist in the long run. But the long run also usually allows other firms to enter profitable markets. However, this doesn’t happen in monopolistic markets due to barriers to entry.

Keeping others out with barriers to entry

A critical characteristic of monopoly is the presence of barriers to entry. However, different barriers to entry exist. The different barriers to entry lead to different types of monopoly.