Monopolistic Competition: Long-Run Equilibrium
In __monopolistic competition__, there are many firms, and barriers to entry are assumed to be low. Consider why a firm would enter a monopolistically competitive industry. What would be the most accurate way to describe market entry into such an industry?
Correct!
Economic profits lure new firms into the industry. Economic losses also drive firms out of the industry.
Incorrect.
Note that when prices equal average cost, economic profit is zero. Firms would not be expected to enter an industry where no economic profits are being earned.
Incorrect.
In fact, when the typical firm is experiencing economic losses, you could eventually expect that firm to leave the industry or shut down.
Recall that a monopolistically competitive industry is typically populated with numerous firms, each of which shares overall market demand. When firms enter a monopolistically competitive industry, that has a bearing on the existing "incumbent" firms. What do you think is most likely to happen when new firms enter the market?
Incorrect.
As long as economic profits are being earned in the short run, you can expect firms to enter the industry. Think of it this way: Economic profits suggest that there is “room” for other competitors.
Correct!
This is illustrated as a leftward shift in the typical firm’s demand curve.
Incorrect.
In fact, you can expect firm entry to place downward pressure on prices.
As new firms enter the market, they reduce demand for existing firms, thereby shifting each firm’s demand curve to the left.
Take a look at the three panels below, and assume that each represents the typical firm in a monopolistically competitive industry.
In which panel would you expect to observe firms entering?
Incorrect.
In fact, this firm is incurring economic losses (i.e., earning negative economic profit). At the optimal rate of output, average costs per unit exceed price. If this were the case for all firms, firms would be unprofitable, and eventually some of them would be expected to exit the market.
Correct!
In this panel, the typical firm is earning economic profit. Entrepreneurs will observe that, and they will enter the market in hopes of taking some market share—and profit—from existing producers.
Incorrect.
Panel _C_ shows a firm that is earning zero economic profit. At the optimal rate of output, price equals average cost. It is unlikely that firms would be attracted to a scenario where zero economic profits were being earned by the typical firm.
When monopolistically competitive firms enter an industry, they take market share (and demand) from incumbent firms. That process is beneficial to consumers, as it increases the variety of goods being sold. How would you describe the process of firm entry in monopolistically competitive industries in the long run?
Correct!
In monopolistic competition, this process of firm entry would drive prices lower until economic profits were reduced to zero. At that point, other firms would no longer enter the market. As such, you can assume that in the long run economic profits are equal to zero.
Incorrect.
In the short run, this may be true. But in the long run, firm entry is likely to reduce prices, and by extension, reduce each firm’s economic profit.
Incorrect.
In the short run, it is plausible to imagine a scenario where economic profits are negative. But in the long run, you can expect that some firms would shut down in response to negative economic profits. When they did so, demand for those firms that continued to operate would increase, and their optimal price would rise.
In perfect competition, the process of firm entry and exit causes prices to reach the lowest possible point on the average cost curve. That scenario is illustrated in the diagram below, with the lowest possible point on the average cost curve noted as point _A_.
A similar process occurs in monopolistic competition: The entry of new firms causes prices to fall. However, the long-run outcome in monopolistic competition differs from that observed in perfect competition. As is illustrated in the diagram below, the long-run price in monopolistic competition does not reach the lowest possible point on the average cost curve (point _A_) but instead tends toward something higher (point _B_).
How might you explain the tendency toward a higher price in monopolistic competition, relative to perfect competition?
Incorrect.
It is true that these firms face higher barriers to entry, but that does not fully explain why costs do not reach the lowest point on the average cost curve in the long run.
Incorrect.
It is true that monopolistically competitive firms are price makers, which means that they have some influence over price. But they are not able to set prices at any level they desire. Recall that there are numerous firms in this market structure. Higher prices will simply drive customers to competitor firms.
Correct!
Recall that product differentiation is a key characteristic of the monopolistically competitive industry. As firms seek to differentiate their product, they incur costs, and these additional costs lead to a downward-sloping demand curve due to the ability to differentiate their products. Such additional costs are not borne by perfectly competitive firms that do not differentiate (i.e., advertise) their homogeneous product.
In summary, as with perfect competition, firm entry places downward pressure on prices in monopolistically competitive industries. Unlike in perfect competition, however, in this situation that process does not force price to the lowest possible cost (i.e., the lowest point on the AC curve). Instead, prices are higher.
This increase in cost can be directly associated with expenses undertaken by the monopolistically competitive producer to differentiate its products.
Where economic profits exist, firms would be expected to enter the industry
When prices equal average cost, firms enter the industry
Where economic losses (i.e., negative economic profits) exist, firms would be expected to enter the industry
As new firms enter the market, other firms must leave the market
The typical existing firm’s market share becomes smaller
As new firms enter the market, the optimal price for the typical firm rises
Panel _A_
Panel _B_
Panel _C_
As firms enter the market, prices are reduced and economic profit earned by each firm decreases
In the long run, monopolistically competitive firms are able to earn economic profit only if they differentiate their product
In the long run, economic profits in monopolistically competitive industries will likely be negative, thereby causing firms to exit the market
Monopolistically competitive firms face higher costs to overcome barriers to entry
Monopolistically competitive firms are able to set prices as high as they desire since they are price makers, so they choose a higher price
Monopolistically competitive firms incur costs, such as for advertising, that perfectly competitive firms do not
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