What is the relationship between economies of scale and a natural monopoly? b.)

Question

What is the relationship between economies of scale and a natural monopoly? b.) Why is the level of output at which marginal revenue equals marginal cost the profit-maximizing output? (Points : 25)

Explanation / Answer

A natural monopoly is where the efficient level of production only allows for a single competitor. If the output level at which a producer realizes the full economy of scale is large enough to supply the entire market, the producer is considered to have a natural monopoly. This is because if there were multiple competitors, they could only be operating at a higher cost than they could otherwise achieve. Eventually one competitor will increase his production and undercut the others, driving them out of business. The reason that you want to operate where marginal revenue equals marginal cost is that you want to make incremental profit on each unit, so you keep producing until you no longer do. For each unit you supply the market, your overall revenue increases while your price per unit falls, until it is no longer profitable to make any more. If you do not make that last unit, someone else will, and this will take some incremental profit away from you. Since the assumption is that each firm is maximizing its profits, they will all keep going until there is no more profit to be had. Profit = TR-TC Profit=P(Q).Q - TC - where TC=F(Q) If you get 1st derivatives Profit(With respect to Quantity)=MR-MC=0 --> where profit is maximum. and therefore MR=MC Graphically, TR is a bell-shaped curve, the highest point of the curve has a tangent with the slope of 0 Logically, is the last item you produced gave you enough revenue to cover it's costs, then if you produce more than that the cost might exceed your revenue from the last item and hence reduce profits (the are past the horizontal tangent)

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