Question

How do selling costs affect equilibrium of a firm operating under monopolistic competition?

Answer 1

Selling costs affect the equilibrium of a firm operating under monopolistic competition in the following way:

1. Shift in Demand Curve: Selling costs, such as advertising and sales promotion expenses, increase demand for the firm's product. This shifts the firm's average revenue (demand) curve upward (to the right), reflecting higher demand due to better product promotion.
2. Increase in Costs: Selling costs are included in the firm’s total costs, resulting in a new higher average composite cost (ACC) curve that lies above the original average production cost (APC) curve.
3. Higher Price and Output: Because of increased demand from selling costs, the firm can sell more output at a higher price. Equilibrium output rises from the initial level to a new higher level, and the equilibrium price also increases.
4. Higher Profits: Profits increase as the higher demand enables the firm to sell more output at a higher price despite the higher costs. The firm continues to incur selling costs as long as the additional revenue from selling costs exceeds the additional selling costs themselves.
5. Profit Maximization in Equilibrium: The firm will keep increasing selling costs to shift demand and increase profits until the marginal revenue from selling costs equals the marginal selling cost. At this point, the firm maximizes profit, and equilibrium is achieved where price, output, and selling costs are balanced.
6. Uncertainty: The exact effects of selling costs on price and output can be uncertain, but generally, they lead to higher prices, increased output, and altered consumer preferences. Advertising may be successful if it makes the demand more inelastic (less sensitive to price changes).