Let's now look at the monopolist business decisions. A monopoly measures its revenue just like any other firm. Total revenue being calculated by the price times the quantity of the goods that they sell. Average revenue is the total revenue divided by the quantity.
Notice though that the average revenue is always going to be equal to the price. In other words, if we take the price times the quantity, we get total revenue. If we take the total revenue divided by the quantity, we get our price.
So the values are always the same. The distinction, though, between this and perfect competition is that, remember, price is the same for all quantity in perfect competition. But in monopoly, that's not the case.
We know this because the monopolist faces a downward-sloping demand curve. That downward-sloping demand curve tells me that if they want to sell more output, that is, they want to increase their Q, they have to reduce the P. So while price and average revenue are the same, they do both decrease over time.
And so that demand curve and the average revenue curve are the same. So as quantity increases, price has to decrease, but so does average revenue. Marginal revenue, on the other hand, is the change in total revenue over the change in quantity, just like for a perfectly competitive firm.
Here, though, the marginal revenue and the average revenue is not equal to each other, nor is it equal to price. The rationale is that for the monopolist, because they have to lower the price in order to sell more output, they face a two-fold shift in what is happening to their revenue. In other words, as they sell more output, they're getting more revenue, but in order to sell more output, they have to lower their price. So let's explore this a little bit deeper.
When we look at the monopolist's marginal revenue, We say that those two effects, the output effect and the price effect, are going to be added together in order to see exactly what happens to the firm's marginal revenue. So the output effect is more quantity is sold, but the price effect is that because more quantity is sold, price has to be lower. So they're fighting each other, if you will, to determine the total or final impact on total revenue. Let's take an example and see what's happening. So let's suppose that we have the following prices.
So a price of 10, 8, and 6. And as a result, we have the following quantities, 2, 3, and 4. We can calculate our total revenue by multiplying the two values together. So P times Q gives us our total revenue. So 10 times 2 gives me 20, 8 times 3 gives me 24, and 6 times 4 gives me 24. Now we want to calculate the marginal revenue. As we go from 2 to 3 units, total revenue increases by 4. As we go from 3 to 4 units, total revenue changes by 0. So it does show that as we're increasing our quantity, marginal revenue is falling. And it's falling faster than price is.
Let's break it down a little bit more into this output effect and price effect. So if the monopolist wants to increase from selling two to three units, what's happening? It's gaining revenue from selling another unit. How much is it able to sell that third unit for?
Eight dollars. So it gained eight dollars as a result of selling the third unit. But the problem is that we assume that this is what we call a single price monopolist.
In other words, they're not going to charge ten dollars for the first two units and eight for the third. They have to charge $8 for all three units. So yes, we gained $8 because now we're selling one more unit, but we also lost $2 for the two units prior to that. In other words, we now have to sell these original two units at $2 apiece less, leaving us with four less dollars in revenue as a result, the net effect being our marginal revenue of four.
What about as we go from three to four? Again, we're selling one more unit. We're going from three to four and we're selling that fourth unit for six.
So we're able to gain $6 as a result. But we're also having to decrease the price by $2 of those previous three units. So each of those three units was being sold for eight.
Now it's only being sold for six. So we're losing $2 for each of those three units or a total of $6. giving us that net effect of zero. So the marginal revenue is a function of both of those values for the monopolist. What that translates to if we go back to our graph is that the marginal revenue curve will always be below the demand curve.
It's going to fall faster as a result of that price and output effect that the monopolist faces. Again, the decision here for the monopolist, unlike the perfectly competitive firm, is that if they want to sell more output, they have to lower their price. A perfectly competitive firm did not have to do that. If they wanted to sell more output, they could sell it at the going market price.
It sounds like a benefit for perfect competition and a downside for the monopolist. But remember, the monopolist is the only firm in the market, and they're going to choose what's profit maximizing. And they can still prevent other firms from coming in.
So it's not all bad. So let's look at profit maximization. When we look at profit maximization, just like every other market structure, we're always going to equate marginal revenue and marginal cost in order to maximize profit.
This walk. always be where we set the quantity that the firm will produce. We then look at and use the demand curve. So we've got a three-step process. We set that marginal cost equal to marginal revenue.
We use that demand curve to get the price that the firm should charge. And then we use our average total cost curve to determine the profit that the firm makes. These are always the same three steps, but We use different demand curves for different market structures, dependent on the types of products that they're producing and the number of firms that they face in competition.
So for a perfectly competitive firm, the price equals the marginal cost and marginal revenue. Because we know that price and marginal revenue are always the same, because the perfectly competitive firm always charges the same price. And they're going to set that to marginal cost, just like anybody else.
But for the monopolist, Their price is greater than that marginal revenue and marginal cost equality. That right there is the key component that gives them that market power. Their ability to charge a price greater than marginal cost is an indication of market power.
And it's what the monopolist capitalizes on in order to get the absolute most profit they possibly can.