Comparable to any profit-maximizing firm, a monopolistically competitive firm produces the quantity of output in the short run that generates the maximum difference between total revenue and total cost, which is economic profit. This profit maximizing level of production is also achieved by the equality between marginal revenue and marginal cost. At this production level, the firm cannot increase profit by changing the level of production. The analysis of marginal revenue and marginal cost can be achieved through a table of numbers or with marginal revenue and marginal cost curves.

Working the Numbers

Because Manny produces a product with a large number of close but slightly different substitutes, he has some market control but not much. As such, he faces a negatively-sloped demand curve, but one that is relatively elastic. To sell a larger quantity, he must lower the price. Manny Mustard's status as a monopolistically competitive firm is reflected in this table.

The Sandwich Numbers

• Quantity: The quantity of output produced by Manny Mustard, presented in the first column, ranges from 0 to 10 sandwiches. While, Manny Mustard could produce more than 10 sandwiches, this range is sufficient for the present analysis.


• Price: The second column presents the price received by Manny Mustard for selling sandwiches. As a price maker, the first and second columns represent the demand facing Manny for his sandwiches. The price Manny faces ranges from a high of $5.25 per sandwich for a zero quantity to a low of $4.75 per sandwich for 10 sandwiches. Manny Mustard can sell a larger quantity of sandwiches, but only by reducing the price. Manny Mustard is a price maker.


• Total Revenue: Total revenue is presented in the third column. This indicates the revenue Manny Mustard receives at each level of sandwich production. It is derived as the quantity in the first column multiplied by the price in the second column. Total revenue ranges from $0 if no output is sold to a high of $47.50 for selling 10 sandwiches. For example, selling 5 sandwiches generates $25 of revenue and selling 8 sandwiches leads to $38.80 of revenue.


• Total Cost: The fifth column presents the total cost incurred by Manny in the production of his sandwiches, ranging from a low of $3 for zero output (which is fixed cost) to a high of $83.70 for 10 sandwiches. Total cost continues to rise beyond 10 sandwiches, but this information is not needed for the present analysis. Producing 1 sandwich incurs a total cost of $8.85. Producing 2 sandwiches incurs a total cost of $12.30. Total cost rises as Manny produces more.


• Profit: The seventh column at the far right of the table contains economic profit, the difference between total revenue in the second column and total cost in the third column. It starts at -$3, falls a bit to -$3.85, rises to $7.80, then falls to -$36.20.

1. Marginal revenue indicates how much total revenue changes by producing one more or one less unit of output.
2. Marginal cost indicates how much total cost changes by producing one more or one less unit of output.
3. Profit increases if marginal revenue is greater than marginal cost and profit decreases if marginal revenue is less than marginal cost.
4. Profit neither increases nor decreases if marginal revenue is equal to marginal cost.
5. As such, the production level that equates marginal revenue and marginal cost is profit maximization.

• Marginal Revenue: The fourth column displays marginal revenue, which declines from a high of $5.20 for the first sandwich to a low of $4.30 for the tenth sandwich. Because Manny is a monopolistically competitive firm with a small degree of market control, marginal revenue is less than price.


• Marginal Cost: The sixth column presents the marginal cost that Manny incurs in the short run for the production of sandwiches. It starts at $5.85, declines to a low of $1.65, then rises to $27.45. The declining values are the result of increasing marginal returns and the rising values are due to decreasing marginal returns and the law of diminishing marginal returns.

• First, a quick look at the profit column indicates that the profit-maximizing production is 6 sandwiches, which generates a profit of $7.80. Click the [Profit Max] button to highlight this result.


• Second, with this outcome highlighted, note the corresponding marginal revenue and marginal cost values. Marginal revenue is $4.70 for the sixth sandwich and marginal cost is $3.45.

  Manny increases production from 5 to 6 sandwiches because doing so generates $4.70 of extra revenue and incurs only $3.45 of extra cost, meaning profit increases by $1.25 over the production of 5 sandwiches. Manny does not increase production from 6 to 7 sandwiches because doing so generates only $4.60 of extra revenue but incurs $5.85 of extra cost, meaning profit decreases by $1.25.

  As such, Feet-First Pharmaceutical settles in with the production of 6 sandwiches and achieves maximum profit. It cannot increase profit by changing production.



• Third, while marginal revenue and marginal cost might not appear to be equal for the profit-maximizing 6 sandwiches production ($4.70 versus $3.85), they really are. The reason is that the marginal numbers in the table actually represent discrete changes from one sandwich to the next. Reducing the size of the discrete change, say from 5.9999 sandwiches to 6 sandwiches, results in marginal revenue and marginal cost that are actually closer to $4.65. At the limit of an infinitesimally small change, marginal revenue and marginal cost are exactly $4.65.

  While the equality between marginal revenue and marginal cost shows up better in a graph, the best practical method of identifying similar results, with a table of numbers, is to average the discrete changes on either side of the quantity. For example, the marginal cost AT the sixth sandwich of sandwich production is the average of the change from 5 to 6 ($3.45) and from 6 to 7 ($5.85), which is $4.65. Marginal revenue AT the sixth sandwich is the average of the change from 5 to 6 ($4.70) and from 6 to 7 ($4.60), which is also $4.65.

Working the Curves

The Sandwich Curves

• Average Revenue: First up is the average revenue curve, which can be seen with a click of the [Average Revenue] button. Because Manny Mustard is a monopolistically competitive firm, this average revenue curve is also its negatively-sloped demand curve.


• Marginal Revenue: A click of the [Marginal Revenue] button reveals the green line labeled MR that depicts the marginal revenue Manny receives from sandwich production. Because Manny is a price maker, this marginal revenue curve is also a negatively-sloped line, and it lies beneath the average revenue (and demand) curve. However, because Manny's demand is relatively elastic, these two curves are close together.


• Marginal Cost: A click of the [Marginal Cost] button reveals a red U-shaped curve labeled MC that represents the marginal cost Manny incurs in the production of sandwiches. The shape is based on increasing, then decreasing marginal returns.

To demonstrate why the equality between marginal revenue and marginal cost is the profit-maximizing production level, consider what results if marginal revenue is not equal to marginal cost:

• If marginal revenue is greater than marginal cost, as is the case for small quantities of output, then the firm can increase profit by increasing production. Extra production adds more to revenue than to cost, so profit increases.


• If marginal revenue is less than marginal cost, as is the case for large quantities of output, then the firm can increase profit by decreasing production. Reducing production reduces revenue less than it reduces cost, so profit increases.


• If marginal revenue is equal to marginal cost, then the firm cannot increase profit by producing more or less output. Profit is maximized.