Final answer:
A monopolistic competitor determines the profit-maximizing output where marginal revenue equals marginal cost, then sets a price based on the demand curve, allowing for profits above marginal cost due to product differentiation and market power.
Step-by-step explanation:
A monopolistic competitor sets its profit-maximizing quantity and price following a process similar to that of a monopoly. Initially, the firm determines the quantity where marginal revenue equals marginal cost, which is the profit-maximizing level of output. The firm then decides on the price to charge by looking at its perceived demand curve, which is the price consumers are willing to pay for that quantity.
Unlike perfect competitors, a monopolistic competitor has some degree of market power due to product differentiation, allowing it to charge a price above marginal cost. However, the demand curve they face is more elastic than that of a pure monopolist, because there are substitutes provided by competitors.
The resulting price represents the cost of producing one more unit (marginal cost) plus an amount that contributes to profit maximization. Barriers to entry can protect these profits in the long run, making this strategy sustainable for the monopolistic competitor.