Question

A monopolistically competitive firm will a. maximize profits by producing where \(M R=M C\) b. not earn an economic profit in the long run. c. shut down if price is less than average variable \(\operatorname{cost}\) d. do all of the above.

Short answer

In conclusion, a monopolistically competitive firm will maximize profits by producing where \(MR = MC\), will not earn an economic profit in the long run, and will shut down if price is less than average variable cost. The correct option is d (do all of the above).

Step-by-step solution

Option a: Maximize profits by producing where MR = MC

This option states that a monopolistically competitive firm will maximize profits by producing where marginal revenue (MR) is equal to marginal cost (MC). This is true, as a monopolistically competitive firm will increase production if MR > MC, and decrease production if MR < MC, in order to maximize its profits. Therefore, the optimal production level will be attained when MR = MC.

Option b: Not earn an economic profit in the long run

In the long run, a monopolistically competitive firm will not earn an economic profit due to the entry and exit of firms in the market. This process will continue until the market reaches an equilibrium where the firm's profits are equal to its costs, making the economic profit equal to zero. Hence, this statement is also true.

Option c: Shut down if price is less than average variable cost

This option states that a monopolistically competitive firm will shut down if the price that it receives is less than its average variable cost. This is indeed true, as when the price is less than the average variable cost, the firm cannot cover its variable costs, and it's more beneficial for the firm to shut down and reduce its losses rather than continue production.

Option d: Do all of the above

Since we have analyzed each of the given options (a, b, and c) and found that all of them are valid statements about the behavior of a monopolistically competitive firm, option d (do all of the above) must be the correct choice. In conclusion, a monopolistically competitive firm will maximize profits by producing where MR = MC, will not earn an economic profit in the long run, and will shut down if price is less than average variable cost. The correct option is d (do all of the above).

Key concepts

Profit Maximization

In monopolistic competition, firms strive to maximize their profits by deciding how much to produce. This profit maximization occurs at the point where marginal revenue (MR) equals marginal cost (MC). But what does this mean exactly?
- **Marginal Revenue (MR)** refers to the additional revenue a firm earns when it sells one more unit of a product. - **Marginal Cost (MC)** signifies the additional cost incurred from producing one more unit of a product. The firm will evaluate its production levels by comparing MR to MC for each additional unit produced.

• If MR is greater than MC, the firm can increase its profits by producing more because the revenue from selling an extra unit exceeds the additional cost of producing it.
• If MR is less than MC, producing additional units would lead to higher costs than revenue, causing a reduction in profits. Therefore, production should be decreased.
• When MR equals MC, the firm is said to be maximizing its profit because any deviation by either increasing or decreasing production would not lead to higher profits.

Long Run Equilibrium

In the long-term perspective, monopolistic competition adjusts due to the dynamics of market entry and exit, ultimately leading to a state of equilibrium where firms do not earn economic profits. Here's why this happens:
- **Market Entry and Exit:** When firms in monopolistic competition see economic profits in the short run, new firms are attracted to the market. This increase in competition reduces the market share, demand, and price for existing firms. - **Equalized Profits and Costs:** As new firms enter, prices and profits are driven down. Conversely, if firms face losses, some may exit the market, reducing competition and allowing surviving firms to stabilize. In the long run, firms reach a point where the profit they earn just covers their opportunity costs, leading to zero economic profit, no incentive for new firms to enter, and sustaining only those businesses that can efficiently cover their costs.
This equilibrium state ensures:

• The price equals the average total cost (ATC), so firms cover all necessary expenses.
• Economic profits are zero, providing neither losses nor excess profits that could draw new firms.

Shutdown Decision

A critical decision for any firm in a competitive market is deciding when to continue operations and when to shut down. For a monopolistically competitive firm, the shutdown decision hinges on a comparison between the price and the average variable cost (AVC):
- **Average Variable Cost (AVC):** This is the firm's total variable costs divided by the quantity of output produced; importantly, it includes costs that vary with production levels such as labor and raw materials. The firm should consider:

• If the market price falls below AVC, it indicates that the firm cannot cover its variable costs, let alone its fixed costs. In this scenario, the most prudent action is to temporarily shut down to minimize losses, as continuing to produce will only add to the financial burden.
• However, if the price is just sufficient to cover the AVC, the firm might continue operating in the short run to cover at least part of its fixed costs and hope for better prices in the future.

By evaluating these factors, a firm can make an informed decision about whether remaining in operation is viable or if temporary closure is the best strategic move.