CHAPTER 10 • Market Power: Monopoly and Monopsony 361 Price MC P1 P* AC P2 Lost Profit from Producing Too Little (Q 1) and Selling at Too High a Price (P1) D = AR Lost Profit from Producing Too Much (Q 2) and Selling at Too Low a Price (P2) MR Q1 Q* Q2 Quantity F IGURE 10.2 PROFIT IS MAXIMIZED WHEN MARGINAL REVENUE EQUALS MARGINAL COST Q* is the output level at which MR ϭ MC If the firm produces a smaller output—say, Q1—it sacrifices some profit because the extra revenue that could be earned from producing and selling the units between Q1 and Q* exceeds the cost of producing them Similarly, expanding output from Q* to Q2 would reduce profit because the additional cost would exceed the additional revenue An Example To grasp this result more clearly, let’s look at an example Suppose the cost of production is C(Q) = 50 + Q2 In other words, there is a fixed cost of $50, and variable cost is Q2 Suppose demand is given by P(Q) = 40 - Q By setting marginal revenue equal to marginal cost, you can verify that profit is maximized when Q = 10, an output level that corresponds to a price of $30.3 Note that average cost is C(Q)/Q ϭ 50/Q ϩ Q and marginal cost is ⌬C/⌬Q ϭ 2Q Revenue is R(Q) ϭ P(Q)Q ϭ 40Q − Q2, so marginal revenue is MR ϭ ⌬R/⌬Q ϭ 40 − 2Q Setting marginal revenue equal to marginal cost gives 40 − 2Q ϭ 2Q, or Q ϭ 10