Question

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

Short answer

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

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.

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).

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.

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.

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.

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).