Theory of Price and Output Determination
- A firm is a single producing unit
- an industry is a group of firms producing homogeneous products. Equilibrium of a firm means the output at which it maximises profit. Two approaches: (1) TR-TC approach — profit is maximum where the vertical gap between TR and TC is the largest
- (2) MR-MC approach — equilibrium where MR = MC and MC cuts MR from below (sufficient condition). Under perfect competition the firm is a price taker (P = AR = MR) and equilibrium is at MR = MC. Under monopoly the firm is a price maker (downward AR, MR below AR) and equilibrium is also at MR = MC but at a higher price and lower output than perfect competition.
In this chapter
Firm and Industry
A firm is a single producing unit that combines factors of production to make goods or services for profit (e.g. one Wai Wai noodle factory in Kathmandu). An industry is a group of firms producing the same or similar products (e.g. all instant noodle producers in Nepal — Wai Wai, Rara, Mayos — together form the noodle industry). The output of the industry is the sum of outputs of all its firms. The price of the good is determined by the industry's market demand and supply; each individual firm in perfect competition then takes this price as given.
Equilibrium of the Firm: Two Approaches
- TR-TC approach: total profit π = TR − TC. Profit is maximum where the vertical gap between the TR curve and the TC curve is the largest, with TR above TC.
- MR-MC approach: profit is maximum where MR = MC (necessary condition) AND MC cuts MR from below** (i.e. MC is rising at the equilibrium point — sufficient condition). The MR-MC approach is more commonly used because it focuses on the marginal (last) unit, which is what the firm actually decides
TR-TC approach: profit maximisation
MR-MC approach: necessary and sufficient conditions
Profit per unit and total profit
Equilibrium under Perfect Competition
Under perfect competition the firm is a price taker — the industry demand and supply determine P, and the firm faces a horizontal AR = MR = P line. Equilibrium is at the output where MR = MC and MC is rising. Short run: the firm can earn supernormal profit (P > ATC), normal profit (P = ATC), or loss (P < ATC). If P < AVC, the firm shuts down. Long run: free entry and exit drive economic profit to zero — every firm earns only normal profit (P = minimum ATC). Equilibrium of the industry is where market demand equals market supply (Qd = Qs).
Equilibrium under Monopoly
Under monopoly the firm is a price maker — it faces the entire market demand curve (downward AR, MR below AR with same intercept and twice slope). Equilibrium is again where MR = MC and MC cuts MR from below. The monopolist produces less and charges a higher price than a perfectly competitive industry would. Short run: supernormal profit, normal profit, or loss possible. Long run: because entry is blocked, the monopolist can earn supernormal profit even in the long run — this is the key difference from perfect competition. Example: Nepal Electricity Authority (NEA) is a monopoly in electricity distribution — barriers (huge capital, legal licence, transmission network) prevent competitors, and NEA can earn long-run profit (when it manages costs well).
Perfect competition vs Monopoly — equilibrium comparison
| Aspect | Perfect Competition | Monopoly |
|---|---|---|
| Price | Given by market; firm is price taker | Firm sets price; price maker |
| AR / MR | AR = MR = P (horizontal) | AR downward; MR below AR |
| Equilibrium condition | MR = MC, MC rising | MR = MC, MC rising (same) |
| Equilibrium output | Larger | Smaller |
| Equilibrium price | Lower (P = min ATC in long run) | Higher |
| Long-run profit | Only normal profit (P = ATC) | Supernormal profit possible |
| Welfare | Efficient (no deadweight loss) | Deadweight loss (less output) |
| Nepal example | Vegetable vendor in Kalimati | NEA electricity distribution |
Welfare loss under monopoly
Compared to perfect competition, a monopolist produces less and charges more — so some mutually beneficial trades do not happen. The lost welfare is the deadweight loss, the triangular area between the demand curve and the MC curve over the output that the monopolist does not produce. This is why governments regulate monopolies like NEA — to protect consumers from excessively high prices.
Practice Problem
A perfectly competitive vegetable vendor in Kalimati faces price P = Rs 30 per kg (given by the market). Her total cost function is TC = 100 + 10Q + 2Q². (a) Find the profit-maximising output. (b) Calculate TR, TC, and profit at that output. (c) Should she continue production in the short run? Why or why not?
Practice Problem
The NEA faces a linear demand for electricity P = 12 − 0.5Q (P in Rs/unit, Q in crore units). Its total cost function is TC = 4Q + 4 (Rs crore). (a) Find AR, MR, MC. (b) Find the profit-maximising output, price, and profit. (c) Compare this monopoly outcome with the perfectly competitive outcome (P = MC).
Practice Problem
A monopolist in Pokhara faces demand P = 100 − 5Q and has TC = 200 + 20Q. (a) Find the profit-maximising output and price. (b) Calculate the monopolist's profit. (c) Verify the second-order (sufficient) condition: MC must be rising at the equilibrium (i.e. dMC/dQ > 0).
Quick Revision
- Firm = single producer; Industry = group of firms producing similar goods.
- Two equilibrium approaches: TR-TC (max gap), MR-MC (MR = MC, MC rising).
- Necessary condition: MR = MC; Sufficient: MC cuts MR from below.
- Perfect competition: P = AR = MR; firm is price taker; long-run P = min ATC.
- Monopoly: AR downward, MR = a − 2bQ; firm is price maker; long-run supernormal profit.
- Monopoly vs PC: monopoly charges higher P, produces less, creates deadweight loss.
- Profit = (P − ATC) × Q; positive if P > ATC, zero if P = ATC, negative if P < ATC.
- Short-run shut-down: P < AVC; long-run exit: P < ATC.