Question

Under monopolistic competition in the short run, the firm may earn supernormal profits.

Short answer

Answer: In the short run, a monopolistically competitive firm can earn supernormal profits by setting its output level where its marginal cost (MC) equals its marginal revenue (MR). At this point, the firm can charge a price that is greater than its average total cost (ATC) for the profit-maximizing output level. Supernormal profits occur when the demand curve lies above the ATC curve, and the area between the demand curve and the ATC curve up to the profit-maximizing output level represents the supernormal profit earned by the firm.

Step-by-step solution

Define monopolistic competition and short run

Monopolistic competition is a market structure in which there are many firms selling differentiated products, and there are no barriers to entry. In the short run, the number of firms in the market is fixed, and each firm may adjust its output levels and prices based on the current market conditions.

Determine the demand and marginal revenue for the firm

In a monopolistic competition, each firm faces a downward-sloping demand curve for its product. The demand curve for the firm shows the price at which the firm can sell its output. The marginal revenue curve, which represents the additional revenue generated by selling one more unit of output, lies below the demand curve. This is because, in order to sell an additional unit, the firm needs to lower the price not only for the additional unit but also for all previous units.

Determine the firm's cost curves

In the short run, we will focus on the firm's average total cost curve (ATC) and marginal cost curve (MC). The ATC curve shows the average cost of producing different levels of output, while the MC curve illustrates the additional cost incurred by producing one more unit of output. Typically, the MC curve intersects the ATC curve at the lowest point of the ATC curve.

Find out the profit-maximizing output level and price

To maximize its profit, a monopolistically competitive firm will produce where its marginal cost (MC) is equal to its marginal revenue (MR). This condition ensures that the firm is not earning more from producing an extra unit than it costs to produce it. Graphically, this point is the intersection of the MC and MR curves.

Determine the firm's short-run profit

Now that we have the profit-maximizing output level, we can determine the firm's short run profit. Locate the point on the demand curve corresponding to the profit-maximizing output level. This will give us the price that the firm can charge for its product. Next, find the average total cost (ATC) at this output level. To calculate the profit per unit, subtract the average total cost from the price. Finally, to find the total profit of the firm, multiply the profit per unit by the quantity of output produced.

Analyze the possibility of supernormal profits

In the short run, under monopolistic competition, the firm may earn supernormal profit if its price is greater than its average total cost (ATC) at the profit-maximizing output level. This will occur when the demand curve lies above the ATC curve. The area between the demand curve and the ATC curve up to the profit-maximizing output level represents the supernormal profit earned by the firm.