Question

Based on marginal revenue/marginal cost analysis, describe how output (Q) and price (P) are determined in monopolistically competitive markets. Why are they determined in this way? [Hint: Think of what firms attempt to optimize and how they go about doing this in monopolistically competitive markets.]

Answer 1

A monopolistically competitive firm is characterized by large number of sellers who sell a differentiated product at their own price. There are no entry and exit barriers. Equilibrium is at the point where marginal cost curve intersects marginal revenue curve from below. Price is determined from demand curve above this point, quantity on x-axis and cost from average cost curve.

In this case, P < AC and firm is in loss, so some firms will exit while new firms enter when the industry is in the profit situation.

Firms maximize profit at this point. In long run, they produce at zero profit where P = AC but not minimum AC.