How equilibrium price and output are determined by a monopoly firm

 Price and Output Determination in Monopolistic firm

Monopolistically competitive industries are made up of a large number of firms, each small relative to the size of the total market. Thus, no one firm can affect market price by virtue of its size alone. But firms differentiate their products, and by so doing gain some control over price.

 

Price/Output Determination in the Short Run

 Since the firm has a downward-sloping demand curve, it will also have a downward-loping marginal revenue (MR) curve. A profit-maximizing firm produces where marginal cost (MC) equals marginal revenue (q0 in the graph below) and charges the price determined by demand (P0).

 

 

In panel (a) of the figure, the monopolistic competitor will make a profit. However, like a monopoly, a monopolistic competitor is not guaranteed to make a profit in the short run. The firm may make a loss in the short run; its profitability will depend on the demand. This is shown in panel

(b) Price/Output Determination in the Long Run

The action in a monopolistically competitive market occurs when the market moves to the long run.

Since other competitors selling a similar good can enter the market, two changes will occur: Firm demand will decrease.

Firm demand will become more elastic.

 

As more firms enter the market, the demand for any one firm will decrease, since the firm is now sharing the market with other firms.

 

A decrease in demand implies a leftward shift in the demand curve. Since the entering firms are producing substitutes for the existing firm’s good, the demand for the existing good will become more elastic. An increase in elasticity implies the demand curve is getting flatter. By combining these effects, as a monopolistically competitive market moves from short-run profits to the long run, the firm’s demand curve will move to the left and get flatter. Furthermore, the demand curve will

continue to move until there are no more firms entering the market. Firms will stop entering the market when profits are zero.

 

This occurs when the demand curve just barely touches (i.e., is tangent to) the ATC curve, as shown in the figure above. Once the demand curve is tangent to the ATC curve, the profit-maximizing price is equal to the average total cost, and thus, profits are zero. In the long run, competition will drive monopolistically competitive markets to make zero profits. The goal of the firm is to try to maintain

as much short-run profit as possible by differentiating its product. Eventually, though, in the long run, economic profits will be zero.