Question

Sleek Sneakers Co. is one of many firms operating in a monopolistically competitive market for shoes.

a. Assume that Sleek is currently earning short-run economic profits. On a correctly labeled diagram, show Sleek's profit-maximizing output and price, as well as the area representing profit.

(10 pts)

b. What happens to Sleek's price, output, and profit in the long-run? Explain this change in words, and show it on a new diagram.

(5 pts)

c. Suppose that over time consumers become more focused on stylistic differences among shoe brands. How would this change in attitudes affect each firm's price elasticity of demand? In the long run, how will this change in demand affect Sleek's price, output and profits.

(5 pts)

Answer 1

a) Figure 1 represent the short run case. A monopolistic competitive firm finds the quantity by equating MR = MC and then charging the price according to the demand curve (P1) in order to maximize the profits. The profit-maximizing quantity for Sleek Sneakers Co. is Q1 and the price is P1.
Since profit = total revenue - total cost = P1*Q1 - average cost *Q1 (since average cost = total cost/Quantity)

At a price of P1, in the short run, Sleek Sneakers Co. earns a profit that is highlighted in green color in figure 1 ( because at a quantity Q1, price is higher than the average total costs).

b) In the long run, seeing the profits, new firms enter into the market so that they can earn profits as well. Now as more and more firms enter in the market, the consumers can choose from similar products that the firms offer. The demand of Sleek Sneakers Co. decrease becasue consumers can buy from other firms as well. This leads to a decline in profits. New firms will keep on entering as long as there are positive profits and will stop once the price becomes equal to the average total cost such that the profits earned becomes 0. This is depicted in figure 2.

As the demand for Sleek Sneakers Co. products falls, demand curve keeps shifting to left and output and price falls. This happens until the price becomes equal to the average total costs.

c) Over time consumers become more focused on stylistic differences among shoe brands. Then, the consumers will be willing to pay a higher price for stylish shoes. This would make demand inelastic which means for a percentage increase in price, the quantity demanded does not change by as much.

This would result in Sleek Sneakers Co. earning normal profits because the price can still remain above the average total costs.

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