Profit Analysis

Graphically show the distribution between consumers and the producers of the incidence of a tax on pure economic rent.

Def: Pure Economic Rent: The income earned by any resource whose supply is (relatively) perfectly inelastic with respect to it's price.

Discussion of Graph to right: If a tax is imposed on an industry resource with a relatively perfect inelasticity of supply, the upward shift in supply (due to the increased cost of getting the resource to market) is not discernible. In addition, since the tax does not effect the demand curve, the supplier bears the full burden of the tax. In the graph suppliers will find that quantity supplied remains fixed (Q_Fixed) while their after tax revenue moves from P_Fixed to the supplier rent decrease. The consumer does not recognize any incidence of the tax.

What is Schumpeter's notion as to the theory of profit?

He felt that creative destruction brought about by innovation in the hands of entrepreneur leads to pure economic profit. The effects of competition erode this profit and bring the disruption in the steady state back into a steady state (normal profit). He believed that the entrepreneur, in creating the temporary monopoly, created the only chance for pure economic profit.

Monopoly

Differentiate between pure monopoly, natural monopoly, and a cartel.

The primary difference between a pure monopoly and a natural monopolist lies in the analysis of their average total cost curves. A pure monopoly (a market in which there is only one supplier of one product) has costs curves that are relatively identical to a firm that is engaged in some form of market competition. In a natural monopoly firm, the average total cost curve will benefit from economies of scale. In situations where this takes place competition may be impractical, inconvenient, or simply unworkable.

In differentiating pure monopoly from a cartel, we look at first the similarities. Like a monopoly, a cartel has the ability to fix prices and limit output like the price-seeking monopolist. However, the key difference is that a cartel is a number of firms engaged in a oligopolistic market who collude to jointly increase their otherwise normal profits to monopolistic levels and of course the pure monopolist is in the business as the sole supplier. This is done through open agreements to divide the market and limit output while fixing prices. Thus relatively numerous firms with relatively limited market share can form a cartel reap the benefits of pure monopoly. In a cartel, there is the ability for members to cheat the others and thus gain relatively higher pure economic profit than the rest of the members.

Graphically show the profit maximization position of a pure monopolist. (Q_Max) See graph to above.

How high will monopoly profits be? What determines this? Can they be negative?

Given a set of cost curves and a demand curve monopolists can manipulate price and quantity supplied to produce where marginal revenue = marginal cost. The profit at this point will be total revenue minus the total cost. The two components that determine this profit are 1) the height of the marginal cost curve for the firm and 2) the characteristics of the demand curve. It is possible that if costs are higher than revenue at the quantity supplied and price when MR=MC, then profits will be negative.

Regulation

Differentiate between anti-trust law and regulation as alternative policies toward monopoly.

We assume that monopolies limit output and charge high prices in their price-seeking efforts for profit maximization. Consumers do not like this and solicit their political representatives to use government to intervene on their behalf to return the benefits of competition to the consumer. We can compare and contrast anti-trust law and regulation as two methods by which monopolies are controlled.

The Sherman Antitrust Act along with the Clayton Act and Federal Trace Commission Act have effectively made it illegal (felony offense) to form or attempt to form a monopoly (trust) in the restraint of commerce (competition). Specifically it outlaws forms of price discrimination, tying contracts, mergers that reduce competition substantially and interlocking directorates among other aspects.

We can draw light to the one case where these antitrust laws work against consumer benefit. Specifically, in the case of natural monopolies. Here we find the traditional anti trust laws limiting the benefit of economies of scale. However, without the antitrust laws there is nothing to stop natural monopolists from exploiting the price-seeking ability of limiting output and raising price. Thus, the government uses forms of regulation to safe guard the consumer. One form of regulation is the limitation of rate-of-returns for natural monopolies. This allows for a monopoly to only charge the price that corresponds with revenue needed for the firm to just earn normal-profit.

Application

Maximize profit for the profit equation below.

Solution:

Step 1: Given Marginal Profit = O at profit max.

Step 2: Marginal Profit = first derivative of Profit

Marginal Profit = 20 (A^-½) - 2

Step 3: Set Marginal Profit to zero, solve for A

0 = 20 A^-½ - 2

20/ A^½ = 2

A^½ = 10

A = 100