Question

1. Use the MR/MC approach and the appropriate graph to show the profit maximizing price and quantity for a firm in monopolistic competition. Assume that the firm is making economic profits in the short-run. Explain what happens to the economic profits in the long-run.

Answer 1

Answer

A firm in monopolistic competition produces the profit-maximizing output at the level where marginal revenue(MR) is equal to the firm's marginal cost of production and then sets the price according to the demand curve it faces in the market.

The following figure shows the profit maximizing price and quantity for a firm in monopolistic competition, that earns economic profits in the short-run.

In the above figure , the 'MC' is the marginal cost curve, and 'ATC' is the average total cost curve of a firm that produces in monopolistic competitive market. The firm faces the market demand curve 'D', and its marginal revenue curve is shown by curve 'MR'. The frirm produces profit-maximizing level of output Q1 at which MR is equal to MC, and then sets the price P1 for this level of output. From the figure we see that the firm's average total cost(ATC) for producing Q1 level of output is 'C'. Now we see that 'C' is less than 'P1'. Thus the firm is making economic profits in the short-run. We get the economic profit by subtracting total cost from total revenue. The firm's total revenue (Price * Quantity) is the area of 'OP1MQ1', and the firm's total cost (ATC * Quantity) of production is the area of 'OCLQ1'. Thus the firm is making economic profit shown by the area of 'CP1ML'(= OP1MQ1 - OCLQ1).

MC ATE - - Quantity

In a monopolistic competition, there is free entry and free exit of the firms in an industry. Now, attracted by the short-run profit of the existing firms, over the long-run many firms enter the market with their products. With the rise of the substitute products in the industry, the supply of the products, and also the competition between the firms increases in the market over the long-run. As a result the individual firm over the long-run, faces a leftward shift of its demand curve in the market with the decrease in the price of its product. The firm allows to decrease the price of its product till it is equal to the ATC, where the demand curve becomes a tangent to the ATC curve. Thus in the long-run, a firm in perfectly competitive market earns a normal or zero economic profit.

The monopolistic firm in the long-run is depicted in the following figure;

In the figure we see that in the long-run,the demand curve is tangent to ATC curve, and the profit-maximizing price is equalto the average total cost. Thus the firm earns a normal or zero economic profit.

-MC — АТС - Quantity MR

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