Question

. Use math and a graph to show that a monopolistically competitive firm maximizes its profit where it is operating at less than full capacity or minimum efficient scale, which is the smallest quantity at which the average cost curve reaches its minimum (the bottom of a U-shaped average cost curve).

Answer 1

Monopolistically competitive firm maximizes its profit when MR = MC. In the below graph, this occurs at point E and the profit maximizing output and prices are Q1 and A. At this quantity, the line cuts the AC curve at point C which is to the left of Minimum AC point denoted by E.

Economic Profit in this firm = area of rectangle ABCD

Operating at full capacity implies operating at point E1 where AC is minimum. However, due to capacity constraints the monopolistic firm operates at E and the firm is characterized by having EXCESS CAPACITY. The firm is therefore said be inefficient.

At E1, Economic Profit = 0 since P = MC

Profit = (P - MC)*Q

At E, the economic profit > 0 as P > MC

MC A AC Price, Cast A Ei AR-DD curve →Q Q,