Question

Question 7:

1. Using the Demand, MC, MR, and ATC curves as well as the appropriate labels, show the firm’s optimal choice of output and price in monopolistic competition and illustrate a situation in which the firm is earning positive economic profits in the short-run.

2. On another diagram, show the long-run equilibrium for the individual firm in monopolistic competition using only the Demand, MC, MR, and ATC curves as well as the appropriate labels.

Answer 1

A firm in monopolistic competition produces that level of output where marginal cost is equal marginal revenue. In the above diagram, short run equilibrium of a monopolistically competitive firm is shown. SAC is short run average total cost curve and SMC is short run marginal cost curve. D is the demand curve of the monopolistically competitive firm and MR is the marginal revenue curve.

The firm is in equilibrium in the short run where marginal cost is equal to marginal revenue. The firm produces that level of output where MC=MR. From the above diagram we can see that SMC=MR at point A and output is Q. The price charged by the firm is determined by the corresponding point on the demand curve at this level of output. The price charged by the monopolistically competitive firm is P. At profit maximising output Q, the average total cost curve lies below the demand curve. It means that the price charged is more than the average total cost and hence the firm is earning positive economic profits. The profits of the firm are equal to PMNB i.e., the shaded portion.

b.)

If the existing firms are earning short run economic profits, then new firms will be attracted to enter the industry to earn these positive economic profits. As such new firms will enter monopolistic competitive industry. As new firms will enter, the demand for existing firms will decrease and demand curve of existing firm will shift to left until it becomes tangent to average total cost curve. When demand curve becomes tangent to average total cost curve, the price charged is equal to average cost and hence the firm earns normal profits only i.e., normal profits only.

In the above diagram, the firm is in equilibrium where LMC=MR at point B. The output produced is M. LAC is the long run average total cost curve.LMC is the long run marginal cost curve. D is the demand curve and MR is the marginal revenue curve. The output produced is M where MC=MR. We can see that at output M, the demand curve is tangent to average cost curve indicating that price is equal to average cost at output M and firm is earning normal profits only. The price charged is P.