Determination of price and quantity supplied by monopolistic firm in the short run

This article describes the process by which a monopoly firm, i.e., a firm that is the only firm selling a particular commodity, selects the quantity to produce and the price to set for the commodity.

Here are some key features of a monopoly firm:

1. The firm is a price setter rather than a price taker -- it can choose any price it wants.
2. However, for a given price set by the firm, and a given quantity that the firm produces, there is no guarantee that the firm will be able to sell all of what it produces. Thus, instead of being told a market price and trying to optimize the quantity, the firm needs to optimize a (price,quantity) pair based on the market demand curve.

The situation is in sharp contrast to that of determination of quantity supplied by firm in perfectly competitive market.

The situation is similar to determination of quantity supplied by firm in oligopoly. In the latter, however, the firm also has to be concerned about the behavior of competing firms, and the response these firms may show to price changes by the firm. Oligopolistic competition is typically studied using tools of game theory.

More generally, when a firm has market power, it has some leeway in setting prices but, in return, has to explicitly consider the market demand curve it faces. When a firm has monopoly, the leeway in setting prices as well as the importance of the market demand curve are maximal.

Similar determinations

Contrast with firm in perfectly competitive market

There are three key differences. The first two are related and the third follows from them:

Parameter Firm in perfectly competitive market Monopolistic firm
control over market price no control. The firm must accept the market price. significant control. The firm sets both its price and quantity of production.
guarantee of selling everything it produces guaranteed, as long as it prices at the market price. no guarantee. The firm needs to choose its price appropriately based on its estimate of the nature of demand and the quantity it produces.
nature of marginal revenue curve (marginal revenue plotted on the vertical axis as a function of quantity produced on the horizontal axis) flat horizontal curve with price coordinate equal to the market price it's complicated, but generally, a downward sloping curve. Roughly speaking, it represents the demand curve facing the firm.

Another way of putting these is that monopolistic firms have more power (in the sense of setting prices) but also more responsibility (in the sense of having to figure what price to set).

Most of the analysis here can be transferred to the perfectly competitive case, with the following change: the marginal revenue curve is replaced by a horizontal curve at value equal to the market price.

Short-run supply choice

Demand curve and total revenue

The firm faces its own market demand curve, i.e., for any value of price it sets, there is a quantity demanded by the market. The firm must meet the entire quantity demanded, so the total revenue to the firm at a given price is the product of the market price and the quantity demanded at the price.