Question

Explain why the firm in an monopolistic competition does not produce where marginal cost crosses demand (that is where a competitive firm would be located) but rather further up demand onto the elastic segment of the demand curve. Note again that the ability of a firm to raise price above the competitive price is termed "Market Power."

Answer 1

In a competitive market, a firm would produce where MC and demand intersect (the rising part of MC is the supply curve).

In contrast, a firm in monopolistic competition will produce where MR = MC. This will determine the quantity produced.

It will then extend this quantity on to the relevant part of the demand curve, and charge a price much above the competitive price. Thus, it can charge a markup. This ability is known as market power.

In the figure, the firm choses Qmax, at the point where MR = MC.

Based on this, it can charge a price Pmax.

The competitive price is Pc, and the competitive quantity is Qc. This is where MC and Demand intersect.

The firm can charge a markup over the competitive price, and this also determines its profit.

In this diagram, the competitive price is also the minimum ATC point. At this point, MC intersects ATC.

The firm's profit is (P - ATC) X Q

In this diagram, the relevant price is Pmax, quantity Qmax, and minimum ATC is at Pc.