Market Structures: Perfect Competition vs. Monopoly Profit Analysis

Posted on Sep 20, 2025 in Economics

Profit Functions and Market Differences

The general profit function is defined as Profit = Total Revenue (TR) – Total Cost (TC).

For a perfectly competitive firm, the profit function is: π = p · y – c(y). Here, p represents the market price, and y is the quantity produced. The firm is a price taker, meaning the price is independent of its output.

For a monopolist, the profit function is: π = p(y) · y – c(y). In this case, p(y) signifies that the price is a function of the quantity produced. The monopolist is a price setter and has control over the supply, influencing the price by adjusting production.

The primary difference lies in the price determination: in perfect competition, price is fixed regardless of output, while in a monopoly, price is dependent on output. Consequently, a monopolist can set prices by reducing production, whereas firms in a perfectly competitive market face direct competitors and must accept the prevailing market price.

A key distinction in profit maximization is that for a monopolist, Price > Marginal Revenue (MR) = Marginal Cost (MC). Conversely, in perfect competition, Price = MR = MC.

Firm Decision Rule and Market Variations

The decision rule for a firm to operate efficiently and maximize profits is when Marginal Cost equals Marginal Revenue (MC = MR). This signifies that the additional cost of producing one more unit is exactly equal to the additional revenue gained from selling it.

If a firm is not operating efficiently, one of two scenarios occurs:

  • MC > MR: The cost of producing an additional unit exceeds the revenue it generates. To improve efficiency and maximize profits, the firm should reduce production.
  • MC < MR: The revenue from producing an additional unit is greater than its cost. To maximize profits, the firm should increase production. While this situation is preferable to MC > MR as it doesn’t result in a loss, it still indicates that the firm could earn more by producing more.

The application of this rule differs based on the market structure:

  • Perfect Competition: Firms are price takers, so Price = MR = MC. The decision rule is directly applied using the market price.
  • Monopoly: Firms are price setters, so Price > MR = MC. The monopolist sets prices above both MR and MC to maximize profits, leading to a different equilibrium point compared to perfect competition.

Monopolist Revenue and Market Equilibrium Analysis

Consider an inverse demand function for a monopolist: p(y) = 20 – y.

  • Monopolist’s Revenue (TR): TR = p(y) · y = (20 – y) · y = 20y – y2.
  • Marginal Revenue (MR): MR is the derivative of TR with respect to y: MR = 20 – 2y.

When plotting the demand function (D-1), the marginal revenue function (MR), and a monotonically increasing marginal cost function (MC):

  • In a perfectly competitive market, the equilibrium occurs where MC intersects MR.
  • For a monopolist, profit maximization occurs where MR intersects the demand curve (D-1). This results in a lower quantity produced (ym) and higher prices (pm) compared to a perfectly competitive market.

The difference in outcomes leads to deadweight loss, represented by a yellow triangle in the graph. This social loss arises because the monopolist’s higher prices and reduced output prevent mutually beneficial transactions from occurring. The red triangle represents consumer surplus (welfare for consumers), and the purple triangle represents producer surplus (welfare for producers). A monopolist’s pricing strategy typically leads to:

  • An increase in producer surplus.
  • A decrease in consumer surplus.