Economics: Monopolistic Competition?

Question

you are hired as the consultant to a monopolistically competitive firm. The firm reports the following information about its price, marginal cost, and average total cost. Can the firm possibly be maximizing profit? If the firm is profit maximizing, is the firm in a long-run equilibrium? If not, what will happen to restore long-run equilibrium?

a. P < MC, P > ATC
I would think that the firm can’t possible be maximizing profit. The firm should raise price, so that price is greater than MC.Since the firm isn’t profit maximizing the firm should raise price, so that price is equal to ATC but greater than MC.

b. P > MC, P < ATC
The firm is maximizing profit. The firm is not in long-run equilibrium since the price is less than ATC.

c. P = MC, P > ATC
The firm is maximizing profit. The firm is not in long-run equilibrium since the price is greater than ATC.

d. P > MC, P = ATC
The firm is maximizing profit. The firm is in long-run equilibrium since the price is equal to ATC.

Answer 1

The answer is D.

The profit maximizing point is determined by the quantity at which marginal cost and marginal revenue are equal. Take that quantity and see what consumers are willing to pay for it (follow a vertical line to the demand curve.) That is the profit maximizing price, which will be higher than marginal cost.

That shows P (price) > (is greater than) MC (marginal cost)
It always will be.

If that price happens to be higher then the ATC (average total cost) then the firm is making an economic profit. If this happens, then other firms will begin to offer substitutes to attempt to capture part of that profit. As this competition increases market supply will increase and the equilibrium price will fall until none of the firms are making economic profit. They will probably be making accounting profit but when you factor in opportunity cost into the equation then they could do no better elsewhere.

In D P (price) = ATC (average total cost). This means that the amount of market supply makes the price too low for new competitors to be falling all over themselves to get in. The company is making zero economic profit also known as normal economic profit.

So this shows they are in the long term equilibrium.

Answer 2

D.