Monopoly: Question 1

1. Explain the level of output at which a monopoly firm will produce.

The assumption that are being made for the theory of monopoly are the following:
○ There is only one firm producing the product so the firm is the industry .
○ Barriers to entry exist, which stop new firms from entering the industry and maintains the monopoly.
○ As a consequence of barriers to entry the monopolist may be able to make abnormal profits in the long run.

Furthermore, in a monopoly the law of demand still exists which says that in order to increase the demand, the firm has to lower its price which is shown by the downward slope of the demand curve. Therefore, a monopolistic firm can't just charge any price, but has to adjust the price to the demand for the product it is selling which also effects the output the firm can make. But what - just like every other firm - a monopolistic firm really wants to do is to maximize its profits. The profit-maximizing point is where the firm's marginal cost is equal to the firm's marginal revenue. Then the firm will produce at the quantity/ output Q1.
But since a monopolistic firm often produces a necessity - most of the time a natural monopoly - , the government intervenes and regulates the price. The government does that because without the regulation the output the firm would make would be way to low and the price would be too high. This would mean that a lot of people would not be able to afford the necessity or to get it because there is not enough produced. The price the government sets is where the average revenue is equal to the average cost. At this price the firm is breaking even and the price is low enough so the population is able to afford it while the output is high enough so everybody is able to get it. This price is called fair return price.