Q

The slope of this average cost curve is given by the expression

AAC/AQ = -400,000Q-2 + 10 The slope of the new demand curve is given by

AP/AQ = -15.6 (same as the original demand curve)

In equilibrium,

Slope of AC Curve = Slope of Demand Curve -400,000Q-2 + 10 = -15.6

Q-2 = 25.6/400,000 Q2 = 400,000/25.6 Q = 125 Units P = AC

= $9,090(125) - $400,000 - $4,640(125) - $10(1252) = $0

This high-price/low-output monopolistically competitive equilibrium results in a decrease in price from $15,320 to $9,090 and a fall in output from 300 to 125 units per year. Only a risk-adjusted normal rate of return will be earned, eliminating Skyhawk's economic profits. This long-run equilibrium assumes that Skyhawk would enjoy the same low price elasticity of demand that it experienced as a monopolist. This assumption may or may not be appropriate. New entrants often have the effect of both cutting a monopolist's market share and increasing the price elasticity of demand. It is often reasonable to expect entry to cause both a leftward shift of and some flattening in Skyhawk's demand curve. To see the extreme limit of the demand curve-flattening process, the case of a perfectly horizontal demand curve can be considered.

The low-price/high-output (perfectly competitive) equilibrium combination occurs at the point where P = MR = MC = AC. This reflects that the firm's demand curve is perfectly horizontal, and average costs are minimized. To find the output level of minimum average costs, set MC = AC and solve for Q:

$4,640 + $20Q = $400,000Q-! + $4,640 + $10Q $10Q = $400,000Q-i Q2 = 40,000 Q2 =«40000 = 200 units P = AC

= $8,640(200) - $400,000 - $4,640(200) - $10(2002) = $0

Under this low-price equilibrium scenario, Skyhawk's monopoly price falls in the long run from an original $15,320 to $8,640, and output falls from the monopoly level of 300 units to the competitive equilibrium level of 200 units per month. The company would earn only a risk-adjusted normal rate of return, and economic profits would equal zero.

Following expiration of its patent protection, management can expect that competitor entry will reduce Skyhawk's volume from 300 units per month to a level between Q = 125 and Q = 200 units per month. The short-run profit-maximizing price of $15,320 will fall to a monopolistically competitive equilibrium price between P = $9,090, the high-price/low-output equilibrium, and P = $8,640, the low-price/high-output equilibrium. In deciding on an optimal short-run price/output strategy, Skyhawk must weigh the benefits of high near-term profitability against the long-run cost of lost market share resulting from competitor entry. Such a decision involves consideration of current interest rates, the speed of competitor imitation, and the future pace of innovation in the industry, among other factors.

The theory of monopolistic competition recognizes that firms often have some control over price but that their price flexibility is limited by a large number of close substitutes. This theory assumes that in making decisions firms do not consider competitor reactions. Such a behavioral assumption is appropriate for some industries but not others. When individual firm actions cause competitors to react, oligopoly exists.

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