Monopoly and competition, sounds like an interesting combo, right? Indeed, the firms in monopolistic competition combine the characteristics of both worlds: perfect competition and monopoly. To understand the monopolistic competition completely, first, we should take a close look at the monopolistic competition in the short run and then continue with the monopolistic competition in the long run. In this article, we will learn all about the structure of monopolistic competition in the short run and learn about the monopolistic competition in the long run in the next one! Ready to dig in? Let’s start learning!
Definition of Monopolistic Competition in the Short-run
Firms in Monopolistic Competition in the Short-run can be called monopolies since they sell slightly differentiated products and face a downward-sloping demand curve. Due to their differentiated products, they have some market power on their products which makes it possible for them to determine their price.
Firms in monopolistic competition determine their price and output decisions in the short run just like a monopoly.
On the other hand, the firms in monopolistic competition face some degree of competition since many firms are active in the market and there are low barriers to entry, similarly to perfect competition.
In the short run, there is high-level competition and dynamic shifts. Therefore, while some firms will make profits, some will incur losses and will have to exit the market.
Before we begin, let's revise some main terms that we will use in our explanations:
Marginal revenue refers to the increase in revenue after the sale of one additional unit of output
Marginal cost is the additional cost of producing one more unit of output
Average total cost is the total cost divided by the total quantity of produced output
Demand Curve is a graphical illustration of the relationship between the quantity demanded of a good and its price
For a refresher on the firms' characteristics in monopolisticaly competitive markets check out - Monopolistic Competition.
Short Run Equilibrium under Monopolistic Competition
In the short run, firms should produce a quantity where marginal revenue equals marginal cost. Doing so, they maximize their profit or minimize their losses, depending on their average total cost (ATC).
Graph of Monopolistic Competition in the Short Run
Let’s analyze a firm’s profit or loss in the monopolistically competitive market in the short run on a graph.
Figure 1. Monopolistic competition in the short run, StudySmarter Original
In Figure 1 above, you can see that the output quantity is represented on the x-axis, and price and cost are illustrated on the y-axis. First, we look at the point where marginal revenue (MR) is equal to marginal cost (MC). This intersection point of marginal revenue and marginal cost is point 1. This point also helps us to define the firm’s equilibrium output. If we look at the corresponding value on the x-axis, we can see that the output quantity in the short-run equilibrium is A in this case.
Next, we should find the price. Since we know the equilibrium output (which is A), all we have to do is look at the corresponding value on the demand curve. Assume that we draw an imaginary vertical line from the equilibrium output up and this line meets the demand curve at point 3. The corresponding price for point 3 on the y-axis determines the value of the price, in this case, it is C. Similarly, we can find the corresponding value of the Average Total Cost at the equilibrium output, which is equal to B.
Profits of Monopolistic Competition in the Short-Run
A firm in a monopolistic competition produces the quantity at the point where marginal revenue equals marginal cost in order to maximize profit or minimize losses. If the corresponding market price is above the average total cost at that point, then the firm will make profit.
In Figure 2 below, we can see an example of a firm in monopolistic competition making profit in the short-run.
Figure 2. Monopolistic competition short-run profit, StudySmarter Original
In Figure 2 above, we see that at point A, the firm’s marginal revenue equals to firm’s marginal cost and the equilibrium output equals 8. We can also see that the price is 10, whereas the average total cost is 8. Since the price is larger than the average total cost at an output level of 10, the firm illustrated in Figure 2 should make a profit, at least in the short-run.
Calculating Profit in the Monopolistic Competition Short-Run
How can we calculate the profit of a firm in monopolistic competition in the short-run?
To calculate a firm’s profit in the monopolistic competition in the short run, first, we should take the difference in price and the average total cost. The difference is the profit per unit of output. Then we should multiply the difference by the equilibrium quantity to get the total profit.
So, we use the following formula:
Examples of monopolistic competition in the short-run making a profit
Let's take a look at an example of monopolistic competition short-run profit calculation:
Using the formula we can calculate the profit of a firm illustrated in Figure 2.
The area of the green-colored rectangle in Figure 2 equals to the profit that this firm is making in the short-run.
Loss of Monopolistic Competition in the Short-Run
Not every firm is lucky to be making a profit in the short-run. In Figure 3 below, we have a firm in monopolistic competition that incurs losses instead of making a profit in the short run.
Figure 3. Monopolistic competition short-run loss, StudySmarter Original
A firm in a monopolistic competition produces the quantity at the point where marginal revenue equals marginal cost. Therefore, the firm in Figure 3 produces the quantity at the point A. We read off the corresponding price from the demand curve at the current output level, which is 8 in this example. Finally, we look at the value of the average total cost for the quantity level of 8, which gives us 10.
What is different in this case? What we have different in Figure 3 compared to Figure 2 is the position of the average total cost and the demand curve. In Figure 3, the average total cost is above the market price since the value of B is higher than the value of C. Therefore, the firm incurs losses, which are minimized at the point where marginal revenue equals marginal cost.
Calculating Loss in the Monopolistic Competition in the Short-Run
How can we calculate the loss? To calculate a firm’s loss in monopolistic competition in the short-run, we should take the difference in the average total cost and the price, this corresponds to the loss per unit of output. Then we should multiply this value by the total quantity to arrive at the total loss figure.
So, we can use the following formula:
Examples of monopolistic competition in the short-run making a loss
Let's take a look at an example of monopolistic competition short-run loss calculation:
Using the formula, we can calculate the loss of a firm illustrated in Figure 3.
In Figure 3, the loss is depicted by the blue-colored rectangle.
The average total cost curve does not cross the demand curve in Figure 3. Therefore, the ATC curve is always above the demand curve. Therefore, the corresponding price for each quantity is always less than the average total cost of production. Because of that, there is no quantity that the firm can produce that would prevent it from making losses. The firm can only minimize the loss by producing the exact quantity where marginal revenue equals marginal cost.
Monopolistic Competition from short-run to long-run
The relationship between the demand curve and the average total cost curve defines whether the firm will make a profit or incur losses in the short run. If the demand curve is above the average total cost curve, then the firm can make a profit. Otherwise, the firm can only incur losses. In such cases, even though the firms that lose money can minimize their losses, they should exit the market in the long run in order to sustain the long-run equilibrium of normal profits
Monopolistic Competition in the Short Run - Key takeaways
- The firms in monopolistic competition determine their price and output decisions in the short run, just like companies in a monopoly.
- In the short run, firms should produce a quantity where marginal revenue equals marginal cost to maximize the profit or minimize the losses.
- If the market price is above the average total cost at the equilibrium output level, then the firm will make a profit. If the average total cost is above the market price, then the firm incurs losses. The loss is minimized at the point where marginal revenue equals marginal cost.
- To calculate a firm’s profit or loss in the monopolistic competition in the short run, we should take the difference in price and the average total cost and multiply it by the equilibrium quantity.
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