Profit determination in monopolistic competition

• Short run equilibrium position of a firm under monopolistic competition

The monopolistically    competitive   firm earns super normal profits (abnormal   profits) in the short run. Equilibrium       is  attained   (profits   are  maximized)    at  a  point   where   marginal    cost(MC) is equal   to marginal  revenue(MR)    and marginal  cost curve  should  cut marginal  revenue  curve  from  below.

Illustration

From the figure above, SMC, is equal to MR at point E. Thus E is the equilibrium point. Corresponding to this equilibrium point, the firm produces OQ output and sells it at a price OP. Thus, the firm earns pure profit to the extent of PABC since total revenue (OPAQ) exceeds total cost of production (OCBQ).

A firm, in the short run, may earn only normal profit if MC = MR < AR = AC occurs. A loss may result in the short run if MC = MR < AR < AC happens

• Long run equilibrium position of a firm under monopolistic competition
  • In the long run, monopolistic competition comes closer to perfect competition because the freedom of entry and exit allows firms to enjoy only normal profit. Because, of free entry  and  exit,  the  abnormal   profits  made  by the  few  firms  in the  short  run attracts new  firms   into  the  industry,     This   increases   the  production    and  supply   of  goods   and services which   are  close  substitutes   hence  a  fall  in  price  and     In  addition,   the  market share  of each  firm and the number  of consumers   reduces  hence  a reduction  in profits,
  • Also as  new  firms  enter  into the  industry,   the  demand   for  raw  materials   increases   which results into an increase   in the  factor  prices  hence  increased   costs  of production.    This forces the average cost curve to shift upwards until it is tangent to the marginal revenue curve.
  • Equilibrium is attained   (profits  are  maximized)    at a point  where  marginal   cost(MC)    is  equal  to marginal        revenue(MR)   and marginal  cost  curve  should  cut marginal  revenue  curve  from   below

  

  From the graph, equilibrium is attained at point E where the marginal cost (LMC) curve is equal to the marginal revenue (MR) curve. At point E, the equilibrium output OQ, is produced and sold at price OP determined at point A.  Therefore, the selling price is equal to the cost price.   This implies that total cost is equal to total revenue and therefore the firm earns normal profits.