Question

Candice operates an ice cream parlor in a small town in Tristate area. She knows that this a monopolistically competitive business because other producers in the area supply different flavors of ice cream. Candice runs her business as efficiently as possible, to maximize her profits. This year, Candice charges $5 per ice cream and experiences marginal cost of $3 and average total cost of $4 per ice cream at the optimal level of output. Does Candice have profits in short term (this year)? Can you predict how ice cream market conditions for Candice will be changing in the near future? What will be Candice's profit in the long-run?

Answer 1

In a monopolistically competitive industry a firm fixes the profit maximizing output where MC=MR. Its profit is the difference between the AR (price) and ATC (unit cost). Candice average revenue is $5 and her average total cost is $4. The difference between the AR and ATC is $1. The Candice earns positive economic profit of $1 in shortrun.

But in longrun new sellers will enter into the market. With the entry of new firms into the market the market supply increase and price falls. Thus in longrun the price charged by Candice and others in the market will be AR=ATC. Thus in longrun Candice earn only normal profit or zero economic profit.

In shortrun Candice earn positive profit since Candice supply ice-cream which is differentiated from others. But in longrun other firm will enter into the market and will produce the same ice-cream as Candice produce. Thus her product differentiation disappears and her monopoly over the product disappears altogether. Thus he has to compete with the other sellers to increase sales. This will compel Candice to reduce her price. On the other hand the entry of new firm increase the market supply of ice-cream and this automatically reduce the market price. In short Candice earns normal profit in longrun.