Up to this point, we have assumed that very special conditions called "perfect competition" obtain. Under these restrictive assumptions, all firms are price takers, too small to affect the price of the goods they produce. There is ease of entry and exit from all industries, allowing resources and people to move freely and rapidly from one area of production to another. We assume perfect knowledge and foresight so that people do not act erroneously through ignorance or error. Finally, there is no product differentiation (advertising) so that all products are assumed to be "generic". In reality, few of these conditions actually exist at all commonly. Economic life is actually far different. Competition is rarely perfect.

Real world competition lies somewhere along a continuum ranging from perfect competition at one end to monopoly (one seller in the industry) at the other.

Between perfect competition at the one extreme and monopoly at the other lie Monopolistic Competition and Oligopoly. These are intermediate competitive categories characterized by decreasing numbers of competitors. Monopolistic Competition has a large number of firms in an industry, each having a small degree of "market power" in the form of such things as brand recognition. Oligopoly is characterized by just a few competitors. How few is subject to interpretation. The automobile industry is considered oligopolistic, and there would seem to be perhaps 20 or so major producers world wide. We have investigated how perfectly competitive firms act. Now it's time to have a look at how firms at the other extreme operate: the Monopolists.

The monopolists sees the industry demand curve as his demand curve. Unlike the perfectly competitive firm which sees only a tiny portion of the industry demand curve, and can thus have no effect on price, the monopolist has the ability to influence price. The monopolist doesn't influence price by setting it at the level he likes, but by varying his rate of output. It's not that the monopolist is free to do what ever he wants, he is constrained by the market. However much he might like to charge whatever he wanted for his product, he cannot do so unless customers are willing to buy output at that price.

If the monopolist wants to charge P1 and sell output at the level of Q2, he is simply out of luck. To achieve a price of P1, the monopolist must limit his out put to Q1. When a monopolist increases output from Q1 to Q2, the price paid in the market falls from P1 to P2. All of the output sold at Q2 is sold at P2 which is the market price. The change in revenue resulting from going from Q1 to Q2 is equal to (P2 * Q2) - (P1 * Q1). This change in revenue is called "marginal revenue". Typically we look at marginal revenue over small changes is Q rather than the somewhat large one we've examined here. If we look at small increases in Q, we generate a new curve called the marginal revenue curve. It represents the change in revenue which occurs with small increases in output. The marginal revenue curve declines twice as rapidly as the demand curve.

Marginal revenue declines rapidly because the decrease in price caused by an increase in quantity applies to all units of the product sold, not just to the incremental one. For this reason, marginal revenue turns negative from roughly the middle of the demand curve on out. Once we're beyond the middle of the demand curve, a one percent increase in quantity (Q) generates a greater than one percent decrease in price (P). This elastic price response means that less total revenue is generated as Q increases beyond the mid section of the demand curve (this is true for linear, straight line demand curves only).

The Monopolist must decided the optimal level of output, just as the perfectly competitive firm does. Like the perfect competitor, the monopolist will produce every unit for which he receives revenue in excess of the incremental cost. Thus he will (like his perfectly competitive cousin) produce out to the point that marginal cost equals marginal revenue. Unlike the perfectly competitive firm, however, marginal revenue does not equal price. It's substantially below it.

The monopolist produces to the point where marginal cost equals marginal revenue (the circled intersection). Note that this intersection is below the demand curve, and yields a price equal to P indicated by the intersection of the vertical line from Q with the demand curve. If this were a competitive industry, production would have continued to the point where MC intersected with the demand curve. This would generate more output at a lower price than the monopoly solution. This is the measure of the inefficiency associated with monopoly: the monopolist produces less and sells at a higher price than would an equally efficient set of competitive firms. Note that it is possible for the monopolist to be more efficient than any realistic set of smaller firms (due to economies of scale), and thus monopoly would be an economically superior outcome since the competitive firms would not be able to match the monopolists price performance.