Final answer:
A monopolist sets the optimal price for profit maximization by first determining the quantity where MR equals MC, then pricing it at the highest level the market demand allows. This is done by extending a vertical line up from the profit-maximizing quantity to the perceived demand curve to find the price. Profits are calculated as the difference between total revenue and total cost.
Step-by-step explanation:
When a monopolist identifies its profit-maximizing quantity of output, it decides what price to charge by referencing its perceived demand curve. Let's break down how this works:
Optimal Pricing for Revenue Maximization
In Step 1, the monopoly determines the profit-maximizing level of output, denoted as Q₁, by finding the point where marginal revenue (MR) equals marginal cost (MC). This is the output level where producing one more unit would no longer increase the firm's profit.
In Step 2, the monopolist sets the price for this output level by drawing a line straight up from Q₁ to the demand curve, reaching point R. The price at point R is considered the optimal price (P₁) for maximizing revenue; it reflects the highest price consumers are willing to pay for quantity Q₁.
Finally, in Step 3, the monopolist calculates its profit by multiplying the quantity Q₁ by the price P₁ to find total revenue. The total cost is determined by multiplying Q₁ by the average cost of producing Q₁, shown by point S on the average cost curve (P₂). The difference between total revenue and total cost is the profit, depicted as the shaded area in the figure.
Several factors influence this optimal pricing strategy, including the elasticity of demand, the cost structure of the firm, and the degree of market power the monopolist holds. A firm must also consider potential competitors, regulatory constraints, and the potential for market entry when setting prices for long-term profit maximization.