4. A monopolistically competitive firm in the short run is producing where price is $3.00 and marginal cost is $1.50. To maximize profits:
A. The firm should continue to produce this quantity.
B. The firm should increase output and decrease price.
C. The firm should decrease output and increase price.
D. It is unclear what the firm should do without knowing marginal revenue.

Question

4.    A monopolistically competitive firm in the short run is producing where price is $3.00 and marginal cost is $1.50. To maximize profits:
A.    The firm should continue to produce this quantity.
B.    The firm should increase output and decrease price.
C.    The firm should decrease output and increase price.
D.    It is unclear what the firm should do without knowing marginal revenue.

BlackTom AI · Accepted Answer

Here is how to think through the problem step by step, considering each option in turn.
Option A: 'The firm should continue to produce this quantity.' This would imply that the current output is profit-maximizing. However, in a monopolistically competitive setting, the profit-maximizing rule is to set output where marginal revenue equals marginal cost (MR = MC). We are not told MR at this quantity, only price and MC. Since MR is typically less than price in imperfect competition, simply having P = 3 and MC = 1.5 does not guarantee that MR = MC at this same quantity. Therefore, continuing the current quantity is not justifiable based on the given information alone.
Option B: 'The firm should increase output and decrease price.' Increasing output would be appropriate if MR > MC, which would push the MR = MC condition toward a higher quantity. But we do not know MR here, and decreasing price could reduce revenue per unit even if quantity rises. Without knowing MR relative to MC, this action cannot be confirmed as profit-maximizing.
Option C: 'The firm should decrease output and increase price.' This would be sensible if MR < MC, suggesting we are producing too much. Yet again, MR is not provided. In monopoly-like markets, price changes depend on the demand curve faced by the firm, and the decision hinges on MR versus MC rather than a simple move in price opposite to quantity.
Option D: 'It is unclear what the firm should do without knowing marginal revenue.' This option correctly flags the key missing piece: to identify the profit-maximizing quantity, one must compare MR to MC. Without MR, we cannot determine whether we should increase or decrease output (or leave it unchanged). The given price (P = 3) and MC (MC = 1.5) alone do not determine MR, since MR depends on the demand curve and the resulting revenue schedule. 
Put differently, even though MC is well below price, the pivotal condition MR = MC could still require a different quantity than the one producing P = 3, so an informed decision cannot be made from the data provided. Thus, the correct choice is D, because it correctly emphasizes the need for marginal revenue information to determine the profit-maximizing output in a monopolistically competitive market.

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