Monopolistic Competition in the Short Run

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:

$$\begin{gathered} \pi =(P-ATC)\times Q \\ where: \\ \pi -totalprofit \\ P-priceperunitofoutput \\ ATC-averagetotal\cos t \\ Q-totaloutputproduced/sold \end{gathered}$$

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:

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:

$$\begin{gathered} \lambda =(P-ATC)\times Q \\ where: \\ \lambda -totalloss \\ P-priceperunitofoutput \\ ATC-averagetotal\cos t \\ Q-totaloutputproduced/sold \end{gathered}$$

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:

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.