Profit Maximization in Imperfect or Monopolistic Competition

If the firm in an imperfectly competitive market has profit maximizationas an objective, they will produce the output where marginal cost isequal to the marginal revenue. Short run profit maximization is shownin Figure.

In the long run, above normal profits will attract the entry of firms intomonopolistic competition. Below normal profits will encourage firms toexit. As firms enter the market demand is split among a larger numberof firms which will shift the demand for each firm to the left (decrease)and probably make it more inelastic. There are more substitutes. Exitof firms will shift the demand for each firm’s output to the right(increase). Entry to and exit from the industry occur until the profitsfor each firm are normal, i.e. the AR = AC. The results of long runequilibrium in a monopolistically competitive market are shown inFigure.

The logical result of profit maximizing monopolistically competitivemarkets is to encourage firms to build plants that are smaller thanoptimal, i.e. a larger plant can produce with fewer inputs per unit ofoutput (or costs per unit of output). Further inefficiency is expectedsince the inefficient plant is operated at an output level that is lessthan the minimum point on the SRAC. This result is due to the factthat the MR must be lower than AR when AR is negatively sloped.Therefore MR=MC at less than the price which lies on the demand (orAR) function. Since the demand is negatively sloped and AC is usuallyU-shaped, the point of tangency between AR and LRAC (normalprofits) will lie to the left of the minimum cost per unit of output. Thisis sometimes called the “excess capacity theorem;” firms build plantsthat are too small and operate them at less than full capacity.

Short run profit maximization for afirm in imperfect competition occursat the output QBJB. This output level isfound at point J where MR=MC. Atthis level of output, the verticalintersects AC at R. The firm isproducing QBJ Bunits at a cost of C* perunit. Total cost (TC) would be C*QBJB orarea 0QBJBRC* (the area in yellow).The firm can sell QJ units at a price ofP*. Total Revenue (TR) is P*QBJB orarea 0QBJBHP*. Profits (Π=TR-TC) areshown by area C*RHP* or (P*-C*)QBJB.Short run equilibrium in monopolisticcompetition resembles theequilibrium conditions in a monopoly.However, entry in monopolisticcompetition will drive profits tonormal in the long run.

Topic 10. Factors of production’ markets

Tutorial 1

The main characteristics of factors’ markets.