Question

you are hired as the consultant to a monopolistically competitive firm. The firm reports the following information about its price, marginal cost, and average total cost. Can the firm possibly be maximizing profit? If the firm is profit maximizing, is the firm in a long-run equilibrium? If not, what will happen to restore long-run equilibrium?

a. P < MC, P > ATC
I would think that the firm can’t possible be maximizing profit. The firm should raise price, so that price is greater than MC.Since the firm isn’t profit maximizing the firm should raise price, so that price is equal to ATC but greater than MC.

b. P > MC, P < ATC
The firm is maximizing profit. The firm is not in long-run equilibrium since the price is less than ATC.

c. P = MC, P > ATC
The firm is maximizing profit. The firm is not in long-run equilibrium since the price is greater than ATC.

d. P > MC, P = ATC
The firm is maximizing profit. The firm is in long-run equilibrium since the price is equal to ATC.

I think you are on the right track. Recall for a monopolistically competitive firm, the demand curve faced by the firm should be nearly flat (highly elastic). So, price and marginal revenue are nearly the same.

So, for a) raise price to at least MC, (perhaps a bit more). Since P starts greater than raising price will make P even more greater than ATC.

b) firm may or may not be maximizing. Price may be too high

c) As P is greater than ATC and is maximizing, there is no incentive for the firm to change anything. However, the industry may not be in equilibrium. Other firms, seeing profits to be made, may enter, which will increase supply and drive down price. P=ATC is a longrun condition for the perfectly competitive industry.

d) Again, P may be too high.

Answer 1

For each of the four given scenarios, these questions are required to be answered:

Can the firm possibly be maximizing profit? If not, what should it do to increase profit? Is the firm in long run equilibrium? If not, what will happen to restore long-run equilibrium?

Scenario a: \(\mathrm{P}<\mathrm{mc},>\mathrm{ATC}\)

Price is below marginal cost, and since marginal revenue must be below price, we know that marginal revenue must also be below marginal cost. Since the marginal revenue and marginal cost are not equal, the firm is not profit maximizing. Since the cost incurred in producing the last unit (i.e., marginal cost) was greater than the revenue gained from the increasing the sale by that unit (i.e. marginal revenue), the firm should decrease output to increase profit.

The firm cannot be in the long run equilibrium, since the price does not equal average total cost.

Scenario \(b: P>M C, P>A T C\)

Price is above marginal cost, and since marginal revenue must be below price, we do not know whether the marginal revenue is below or above marginal cost. Therefore, the firm is possibly and possibly not profit maximizing.

The firm cannot be in the long run equilibrium, since the price does not equal average total cost.

Scenario c: \(\mathrm{P}=\mathrm{MC}, \mathrm{P}>\mathrm{ATC}\)

Price equals marginal cost, and since marginal revenue must be below price, we know that marginal revenue is below marginal cost. Since the marginal revenue and marginal cost are not equal, the firm is not profit maximizing. Since the cost incurred in producing the last unit (i.e., marginal cost) was greater than the revenue gained from the increasing the sale by that unit (i.e. marginal revenue), the firm should decrease output to increase profit.

The firm cannot be in the long run equilibrium, since the price does not equal average total cost.

Scenario d: \(\mathrm{P}>\mathrm{MC}, \mathrm{P}=\mathrm{ATC}\)

The firm is in long run equilibrium, because price equals the average total cost and the price is above the marginal cost. This phenomenon occurs only in long run equilibrium.

The firm is also profit maximizing. In long run equilibrium, a firm is always profit maximizing.