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Chapter 10: Problem 7

How does a monopolistic competitor choose its profit-maximizing quantity of output and price?

Short Answer

Expert verified
A monopolistic competitor chooses its profit-maximizing quantity of output and price by following these steps: 1. Identify its downward-sloping demand curve and cost structure, which includes fixed and variable costs. 2. Determine the Marginal Cost (MC) and Marginal Revenue (MR) curves. 3. Find the point where MC=MR, which represents the profit-maximizing output level. 4. Draw a vertical line from the intersection point to the horizontal axis to find the profit-maximizing quantity (Q*). 5. Follow a horizontal line from the profit-maximizing output level until it intersects with the demand curve to find the profit-maximizing price (P*). 6. Assess economic profit by comparing the price to the average total cost (ATC) at the profit-maximizing output level. If the price is higher than ATC, the firm is making an economic profit; if it's lower, it's incurring an economic loss; and if they are equal, the firm is earning normal profit.

Step by step solution

01

Understanding Monopolistic Competition

Monopolistic competition is a market structure in which there are many firms selling differentiated products. These firms have some degree of market power, which allows them to set higher prices than perfect competition. However, they still face competition from other firms selling similar products, meaning they cannot set prices as high as a pure monopoly.
02

Identify the Demand Curve and Cost Structure

In monopolistic competition, firms face a downward-sloping demand curve, meaning that as the price of the product increases, the quantity demanded decreases. This demand curve shows the relationship between price and quantity demanded for the firm's unique product. Additionally, the firm will have a cost structure that includes both fixed costs (costs that do not change with the level of production) and variable costs (costs that change with the level of production).
03

Determine the Marginal Cost and Marginal Revenue Curves

Marginal Cost (MC) represents the additional cost of producing one more unit of output. The MC curve is typically upward sloping due to the law of diminishing returns. Marginal Revenue (MR) is the additional revenue earned by selling one more unit of output. Since the firm faces a downward-sloping demand curve, the MR curve is also downward sloping and lies below the demand curve.
04

Profit Maximization Criteria

To maximize profits, a monopolistic competitor will choose a level of output where Marginal Cost (MC) equals Marginal Revenue (MR). This is because at this point, the additional revenue from selling one more unit exactly equals the additional cost of producing it. Mathematically, the profit maximization condition is when MC=MR.
05

Determine the Profit-Maximizing Output and Price

Follow these steps to find the profit-maximizing output and price: 1. Locate the intersection of the Marginal Cost (MC) and Marginal Revenue (MR) curves on a graph. This point represents the profit-maximizing output level. 2. From this intersection point, draw a vertical line down to the horizontal axis to find the profit-maximizing quantity (Q*) that the firm should produce. 3. To find the profit-maximizing price (P*), follow a horizontal line from the profit-maximizing output level on the graph, until it intersects with the demand curve. This is the price that firm should charge for their product.
06

Assessing Economic Profit

To determine whether the monopolistic competitor is making an economic profit or loss at the profit-maximizing output and price, compare the average total cost (ATC) at the profit-maximizing output level to the price being charged for the product. If the price is higher than the average total cost, the firm is making an economic profit. If the price is lower than the average total cost, the firm is incurring an economic loss. If they are equal, the firm is earning normal profit (zero economic profit).

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Most popular questions from this chapter

Aside from advertising, how can monopolistically competitive firms increase demand for their products?

What stops oligopolists from acting together as a monopolist and earning the highest possible level of profits?

Jane and Bill are apprehended for a bank robbery. They are taken into separate rooms and questioned by the police about their involvement in the crime. The police tell them each that if they confess and turn the other person in, they will receive a lighter sentence. If they both confess, they will be each be sentenced to 30 years. If neither confesses, they will each receive a 20-year sentence. If only one confesses, the confessor will receive 15 years and the one who stayed silent will receive 35 years. Table 10.7 below represents the choices available to Jane and Bill. If Jane trusts Bill to stay silent, what should she do? If Jane thinks that Bill will confess, what should she do? Does Jane have a dominant strategy? Does Bill have a dominant strategy? \(\mathrm{A}=\) Confess; \(\mathrm{B}=\) Stay Silent. (Each results entry lists Jane's sentence first (in years), and Bill's sentence second.)

Is a monopolistically competitive firm productively efficient? Is it allocatively efficient? Why or why not?

Continuing with the scenario in question \(1,\) in the long run, the positive economic profits that the monopolistic competitor eams will attract a response either from existing firms in the industry or firms outside. As those firms capture the original firm's profit, what will happen to the original firm's profit-maximizing price and output levels?
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