The Profit Maximizing Price and Quantity in the Short Run
Firms in monopolistic competition face a downward sloping demand curve. The demand curve is flatter (closer to horizontal, or more elastic) compared to the demand curve of the pure monopolist. The graph below illustrates the profit-maximizing price and quantity for a monopolistically competitive firm in the short run. The firm maximizes profits at the quantity where marginal cost equals marginal revenue (at a quantity of 400). The price is found by going straight up to the demand curve, so the profit-maximizing price is $7. At the profit maximizing quantity of 400, average total cost is $6. This means that the firm is making an economic (above-normal) profit. Average profit is $7 minus $6, or $1. This means that total profit is $400 (400 times $1).
Because there are low barriers to entry into monopolistic competition, a firm is not expected to make economic (above-normal) profits in the long run. If a firm is making above-normal profits, then in the long run, existing firms will increase supply, and new firms will enter this industry to take advantage of the lucrative conditions. The increase in the supply will lower the price. This will lower the original firm’s profits back to a normal level (zero economic profits). The opposite occurs when firms lose money.
In the long run, a monopolistically competitive firm earns a normal (average) accounting, or zero economic profits. A firm looks at its cost of production and then marks up its price to obtain a reasonable profit. If firm A marks up its price too much, competing firm B will take advantage of it by charging a lower price. This will cause firm A to lose market share, and it will have to respond by lowering its price. This process occurs in any industry, as long as there is free and unrestricted competition (no government barriers), or the threat of competition. It is rare for a firm in a competitive market to charge excessively high prices and experience above-normal profits in the long run.
The graph below illustrates a monopolistically competitive firm’s long-run equilibrium. The firm makes zero economic profits, so the average total cost curve just touches the demand curve. This is where price (PLR) equals average total cost.
Unlike the perfectly competitive firm, the monopolistically competitive firm’s price is not at the minimum point on the average total cost curve. The profit-maximizing price and average cost are to the left of the minimum average total cost. This means that in terms of average costs the monopolistically competitive firm is not producing at its most efficient point.
Monopolistic Competition as a More-Realistic Model
Monopolistically competitive industries are more common than purely competitive ones. It is rare that two competitive firms sell identical products. Just about all firms, small or large, differentiate. They may include slightly different ingredients or parts in their products, or they differentiate in the way that they package, name, distribute, or provide service to the customer. In order to accentuate these differences, monopolistically competitive firms frequently advertise. Advertising usually occurs on a local scale, because monopolistically competitive firms are small. Advertising benefits the firm by emphasizing the unique aspect of its product. This allows the firm to control its price and reap higher profits in the short run. Advertising can also benefit the consumer by informing her/him of the choices available. The Internet has been an effective advertising tool for many businesses, and has helped consumers in comparing product quality and prices.
For a video explanation of profit-maximization for a firm in monopolistic competition, please watch: