Question

The local hairdresser industry has the market structure of monopolistic competition. Your hairdresser boasts that he is making a profit and that if he continues to do so, he will be able to retire in five years. Use a diagram to illustrate your hairdresser's current situation. Do you expect this to last? In a separate diagram, draw what you expect to happen in the long run. Explain your reasoning.

Short answer

Explain your answer by referring to the short-run and long-run scenarios. Answer: No, the hairdresser will most likely not be able to retire in five years based entirely on the current profits. While they are making a profit in the short-run, the monopolistically competitive market structure implies that new competitors will enter the market over time. This increased competition will decrease the demand for the hairdresser's services, leading to a reduction in profits. In the long-run equilibrium, firms in a monopolistically competitive market earn normal profits, making it difficult for the hairdresser to retire in five years based entirely on the current profits.

Step-by-step solution

Understanding Monopolistic Competition

Monopolistic competition is a market structure where there are many sellers offering differentiated products or services, and there's a low entry barrier for new firms. Firms have some control over the prices they set, and consumers have preferences due to the differentiated nature of the products/services.

Short-Run Scenario Diagram

First, let's draw a diagram for the hairdresser's current situation. On the x-axis, we have the quantity of services offered (Q), and on the y-axis, we have price (P) and costs (C). Draw a downward-sloping demand curve (D) and a marginal revenue curve (MR) below the demand curve. Draw the marginal cost curve (MC) with a U-shape, and average total cost curve (ATC) with a U-shape as well, but above the MC curve. The profit-maximizing output level is where MR=MC. Let's name this point Q1. Draw a vertical line from Q1 to the demand curve to find the price (P1). Then draw a horizontal line from P1 to the ATC curve to find the average total cost (C1) at this output level. The area between P1 and C1, multiplied by Q1, represents the profit.

Analyze the Short-Run Scenario

For now, the hairdresser is making a profit, as the price is higher than the average total cost for the quantity of services provided. This is possible in a monopolistically competitive market in the short run.

Long-Run Scenario Diagram

Now, let's draw a separate diagram for the long-run situation. Assuming there are no barriers to entry, the profit attracts new entrants into the market. Over time, the increase in the number of competitors (other hairdressers in this case) leads to a decrease in demand for the hairdresser's services, and the demand curve shifts to the left (D'). Consequently, the marginal revenue curve (MR') also shifts to the left. At the new intersection of MR'=MC, let's call the new output level Q2 and the corresponding price P2. Draw a horizontal line from P2 to the ATC curve to find the new average total cost (C2) at this output level.

Analyze the Long-Run Scenario

In the long run, the equilibrium in monopolistic competition is achieved when price (P2) equals the average total cost (C2) and there are no abnormal profits. The hairdresser will not be able to sustain the profit in the long run as more competitors enter the market, and the demand for his services decreases. To conclude, while the hairdresser is making a profit in the short-run, it is unlikely that this situation will last in the long run. As more competitors enter the market, the demand will decrease, leading to a reduction in profits. In the long-run equilibrium of monopolistic competition, firms earn normal profits, making it difficult for the hairdresser to retire in five years based entirely on the current profits.