What is the relationship between the elasticity of demand and the price set by a monopolist?

The connection between marginal revenue and elasticity works like this:

• If the demand is elastic, then marginal revenue is positive.


• If the demand is inelastic, then marginal revenue is negative.


• If demand is unit elastic, then marginal revenue is zero.

A Look at the Curves

Revenue and Elasticity

The top panel in the exhibit presents a hump-shaped total revenue curve (TR). It is hump-shaped because Feet-First Pharmaceutical does not charge the same price for each quantity sold. As a monopoly, it must lower the price to sell more output.

The bottom panel then presents the average revenue curve (AR), which is also the market demand curve and the demand curve facing Feet-First Pharmaceutical, and the marginal revenue curve (MR), which indicates the extra revenue received for selling each extra ounce of Amblathan-Plus.

Now consider the price elasticity of the average revenue (demand) curve. A straight-line demand curve such as this one has different ranges of elasticity.

• For relatively high prices and small quantities, the average revenue (demand) curve is relatively elastic.


• For relatively low prices and large quantities, the average revenue (demand) curve is relatively inelastic.


• The average revenue (demand) curve is unit elastic at the exact midpoint of the line, which in this case is 10.5 ounces of Amblathan-Plus.

The key question is how these elasticity alternatives relate to marginal revenue and total revenue.

• When the average revenue (demand) curve is elastic, marginal revenue is positive and total revenue is increasing.


• When the average revenue (demand) curve is inelastic, marginal revenue is negative and total revenue is decreasing.


• When average revenue (demand) curve is unit elastic, marginal revenue is zero and total revenue is not changing.

The Monopoly Dream

To achieve monopoly status, a firm must supply a good that has no close substitutes. Buyers must be forced to buy from the monopoly if they buy the good at all. However, the availability of substitutes is a key determinant of demand elasticity.

• Elastic Demand: A good with many close substitutes tends to have an elastic demand. Because buyers are easily able to switch between substitutes, they are relatively sensitive to price changes.


• Inelastic Demand: A good with very few close substitutes tends to have an inelastic demand. Because buyers are not able to switch between substitutes, they are not very sensitive to price changes.

Are these aspiring monopolies misguided? Should they be searching for goods with elastic demand? Are they unaware of the relation between elasticity and marginal revenue? Do they not know that they can never maximize profit if they produce a good with inelastic demand?

A Profitable Journey

While profit maximization means profit can go no higher, the lack of profit maximization only means profit has NOT reached its peak. It does not mean profit is lacking. It does not mean that a monopoly firm is earning NO profit or incurring an economic loss. The lack of profit maximization ONLY means that the monopoly can take steps to increase profit. It can increase profit by doing something like increasing the price.

If a monopoly faces an inelastic demand curve, increasing the price is exactly what it can do. If the price of a good with inelastic demand is increased, then total revenue and profit also increase. Today the price is $1. Tomorrow the price is $2, and profit increases. The next day the price is $3, and profit increases again. When prices rise so too does profit. As long as demand is inelastic, then profit keeps rising. A "maximum" is not reached.

Is this is such a bad thing for the monopoly?

Not being AT THE MAXIMUM, but ONLY being able to increase profit is not really all that bad. Few firms would turn down the opportunity to be the sole provider of an inelastic product. Sure they might never MAXIMIZE their profit, that is, reach a nice stable equilibrium. But they can increase profit day after day, month after month, year after year, by raising prices. The "problem" is that profit can always go higher.

In the analysis of profit-maximization production, a monopoly NEVER selects an output level in the inelastic range of this demand curve. Feet-First Pharmaceutical NEVER willingly produces more than 10.5 ounces of Amblathan-Plus. Doing so requires that Feet-First Pharmaceutical operate with a quantity that generates negative marginal revenue.

If Feet-First Pharmaceutical found itself doing something like selling 15 ounces of Amblathan-Plus, then it undoubtedly raises the price, which reduces the quantity, which then increases total revenue, and which INCREASES profit. It continues this course until the quantity decreases enough to enter the elastic portion of the demand curve. Only there is Feet-First Pharmaceutical be able to MAXIMIZE profit. However, up to that time, profit merely INCREASES. Not such a bad thing for the monopoly.