Monopoly Theory of Profits

Introduction
In economics, a firm is in a monopoly when, because of the lack of any viable competition, it is
able to become the sole producer of the industry's product. In a normal competitive situation, the
price the firm gets for its product is exactly the same as the Marginal cost of producing the
product. Because the monopoly firm does not have to worry about losing customers to
competitors, it can set a price that is significantly higher than Marginal (Economic) cost of
producing (the last unit of) the product. Therefore, a monopoly situation usually allows the firm
to set a Monopoly price which is higher than the price that would be found in a more competitive
industry, and to generate an economic profit over and above the normal profit that is typically
found in a perfectly competitive industry. The economic profit obtained by a monopoly firm is
referred to as monopoly profit. The existence of a monopoly,and therefore the existence of
a monopoly price and monopoly profit, depend on the existence of barriers to entry: these stop
other firms from entering into the industry and sapping away profits.
Classical and Neo Classical Economic thought
Firms are said to be price takers in a perfectly competitive market, because a customer can
buy goods from one producer as easily as from another. Any good produced by any firm is
a "Perfect Substitute" for any good produced by another firm, thereby causing the firms in the
market to have a horizontal demand curve at the Market Equilibrium Price. Essentially, if the
firm tries to sell widgets above the equilibrium price, customers will simply buy their goods
elsewhere and the firm will lose all of their business. It is commonly stated that a situation in
which exactly comparable goods ("Perfect Substitutes") are available just as easily from one firm
as from another does not exist in most actual markets, with the exception of Commodity markets.
Such ideas focus on the idea that the theory of "perfect competition" is usually a useful idealized
model rather than a naturalistic description). However, in many cases, some "similar" products
(such as butter) are relatively easily interchangeable as close Substitutes; and some firms that
produce different but similar goods may be similar enough to ensure these other firms can
relatively easily switch their manufacturing process to produce the good in question when there
is a high economic profit in producing this other (overly) high priced product. This would be the
case when the firm's cost of changing their manufacturing process to produce the different but
similar good can be relatively "immaterial" in relationship to the firm's overall profit and cost.
Therefore, since consumers will tend to replace goods whose price are relatively high for cheaper
goods that are "Close Substitutes", and firms with similar manufacturing processes can switch
over to producing another overly high priced good, the Perfect Competition Model will still
accurately explain why the existence of different firms producing "similar
goods" form competitive forces that deny any single firm the ability to establish a monopoly in
their product (as shown in a high profit and production cost industry such as the car industry and
many other Industries facing Competition from Imports).
By contrast, lack of competition in a market creates a downward sloping demand curve for
a monopolist (or oligopolist): although they will lose some business by raising prices, they will
not lose it all, and it may be more profitable in most situations to sell at a higher price. Though
monopolists are constrained by consumer demand, they are not price takers. The monopolist can
either have a target level of output that will ensure the Monopoly Price for the given consumer
demand it faces in the industry, or it can set the Monopoly Price at the onset and adjust output to
ensure no excess inventories occur as a result of the output level. Essentially, they can set their
own price and accept a level of output determined by the market, or they can set their output
quantity and accept the price determined by the market. The price and output are co-determined
by consumer demand and the firm's production cost structure.
A firm with monopoly power setting prices will typically set price at the profit maximizing
level. The most profitable price that they can set (what will become the Monopoly Price) is
where the optimum output level (where marginal cost (MC) equals marginal revenue (MR))
meets the demand curve. Under normal market conditions for a monopolist, this price will be
higher than the Marginal (Economic) cost of producing the product, thereby indicating the price
paid by the consumer, which is equal to the marginal benefit for the consumer, is above the
firm's marginal cost. In the chart below the shaded area represents the profits of the monopolist,
such that MR = MC for the case of monopoly. The lower half represents the normal profits that
would go to a competitive firm (ignoring output losses). The upper-half represent the additional
economic profit going to the monopolist.

Persistence
In the absence of barriers to entry and collusion in a market, the existence of a monopoly,
and therefore monopoly profit, cannot persist in the long run. (Note that a barrier can be caused
by increasing returns to scale — a bigger firm can produce more cheaply. If the most efficient
size firm serves the whole market, we have a "natural monopoly," and no other firms will "rush"
to enter.) Normally, when economic profit exists within an industry, economic agents rush to
form new firms in the industry in an effort to obtain at least a portion of the existing economic
profit. As new firms enter the industry, they increase the supply of the product available in the
Market, and these new firms are forced to charge a lower price to entice consumers to buy the
additional supply these new firms are supplying (they compete for customers). Since consumers
will flock toward the lowest price (in search of a bargain), older firms within the industry
actually face losing their existing customers to the new firms entering the industry, and are
therefore forced to lower their prices to match the lower prices set by the new firms. New firms
will continue to enter the industry until the price of the product is lowered to the point that it is
the same as the average economic cost of producing the product, and all of the economic profit
disappears. When this happens, economic agents outside of the industry find no advantage to
entering the industry, supply of the product stops increasing, and the price charged for the
product stabilizes. Essentially, a competitive situation always leads to an equilibrium solution".
Normally, a firm that introduces a brand new product can initially secure a monopoly for a short
while. At this stage, the initial price the consumer must pay for the product is high, and the
demand for, as well as the available of the product in the market, will be limited. In the long run,
however, when the profitability of the product is well established, the number of firms that
produce this product will increase until the available supply of the product eventually becomes
relatively large, the price of the product shrinks down to the level of the average "Economic
cost" of producing the product. When this finally occurs, all monopoly associated with producing
and selling the product disappears, and the initial monopoly turns into a (perfectly) competitive
industry.
When consumers have full information about the prices available in the market and the quality of
the products sold by the various firms, there cannot be a persistent monopolistic situation in the
absence of barriers to entry and collusion. Various barriers to entry include patent rights and
monopolization of a natural resource needed to produce a product. The American firm Alcoa
Aluminum is a historical example of a monopoly due to natural resource control; their control of
"practically every source of bauxite in the United States" (bauxite is used to produced aluminum)
was one key reason that "Alcoa was, for a long time, the sole producer of aluminum in the
United States."