Applying third-degree price discrimination

Chapter 13: Monopolistic Competition: Competitors, Competitors Everywhere

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Figure 13-1:

Short-run profit maximization in monopolistic competition.

Marginal cost is the change in total cost that occurs when one additional unit of output is produced. Because of diminishing returns, marginal cost, MC, is upward-sloping, as illustrated in Figure 13-1. In addition, marginal cost passes through the minimum point of the average-total-cost curve, ATC. I describe these relationships in more detail in Chapter 8.

The firm’s total profit increases if an additional unit of output adds more to revenue than it adds to cost. As long as the marginal revenue of an additional unit exceeds marginal cost, as is the case at qA, producing that unit increases the firm’s total profit, and the firm should continue to produce more. On the other hand, if a unit of output adds more to cost than it adds to revenue, as with qB, or if marginal cost is greater than marginal revenue, producing that unit decreases the firm’s total profit. The firm needs to reduce production. The monopolistically competitive firm maximizes profit by producing the quantity of output associated with marginal revenue equals marginal cost. The profit-maximizing quantity of output is represented by q0 in Figure 13-1.

After determining the profit-maximizing quantity of output, the firm establishes the good’s price by going from that quantity, q0 in Figure 13-1, to the demand curve and across to the vertical axis. The profit-maximizing price is P0 in Figure 13-1.

The monopolistically competitive firm determines profit per unit by subtracting average total cost from price. In Figure 13-1, profit per unit is represented by π/q and equals price minus average total cost. Total profit, π, equals profit per unit multiplied by the profit-maximizing quantity, or