Question

A student makes the following comment: I can understand why a perfectly competitive firm won't earn a profit in the long run because it charges a price equal to marginal cost. But a monopolistically competitive firm can charge a price greater than marginal cost, so why can't it continue to earn a profit in the long run?

Short answer

A monopolistically competitive firm cannot continue to earn a profit in the long run because of the low barriers to entry. This situation allows new firms to enter the market when they see others making a profit. The consequent increase in competition and decrease in demand eliminates the companies' ability to charge more than the marginal cost, which erodes the profit. On the other hand, perfectly competitive firms do not make long-term profits because they are price takers and can’t set a price higher than the marginal cost.

Step-by-step solution

Characteristics of a Monopolistically Competitive Firm

A Monopolistically competitive firm is a type of market structure where several or many sellers produce similar, but differentiated products. Differentiated products are the key character of such firms, which means products are somewhat different from each other in branding, quality, design, features, location and more. This gives the firm some amount of market power to set its own price, which is often higher than the marginal cost.

Entry and Exit in the Long Run

In the long run, if firms earn positive economic profits, this will attract new firms into the market, since there are few barriers to entry in monopolistic competition. As new firms enter, the demand for the product of the existing firms will decrease, because buyers now have more products to choose from. This decrease in demand decreases the price and profit of the existing firms until they reach a state of zero economic profits.

Comparing Perfect Competition and Monopolistic Competition

In contrast, in perfect competition, firms cannot earn long-term profits because they are price takers, they settle for the equilibrium price fixed by market supply and demand. Unlike a monopolistically competitive firm, they do not have the ability to differentiate their product or set its price. Thus, any profit they make will quickly vanish due to the price being equal to the marginal cost.

Key concepts

Long-run Equilibrium

In the world of monopolistic competition, understanding the concept of long-run equilibrium is crucial. This market structure consists of many firms, each producing slightly different products. In the short term, firms can earn economic profits due to their ability to set prices above marginal costs. This arises from product differentiation, a distinctive feature of monopolistic competition.

However, in the long run, economic profits attract new firms into the industry. With more firms entering the market, consumers have a wider range of products to choose from, which dilutes the demand for any single firm's product. Consequently, the demand curve each firm faces becomes more elastic.

Over time, this leads to a new equilibrium where firms will no longer earn economic profits. Instead, they earn just enough to cover their costs, resulting in zero economic profits. This is because the entry of new competitors increases supply, drives down prices, and erases earlier profits. Simply put, the long-run equilibrium in monopolistic competition balances out between many firms, each earning just enough to stay in business without making extra profits.

Product Differentiation

Product differentiation is the backbone of monopolistic competition. It refers to the strategy where firms make their products stand out from the competition through various features. These can include branding, quality differences, unique features, or exceptional customer service.

In monopolistic competition, firms differentiate their products to gain some control over pricing. This market power allows firms to charge a price greater than marginal cost, unlike in perfect competition where firms are price takers.

Differentiated products appeal to specific consumer preferences. Each firm attempts to make its product unique enough to build a loyal customer base and reduce direct competition from other firms in the market. This loyalty provides firms some leeway in pricing, as consumers may be willing to pay a premium for their preferred product.

Through effective product differentiation, firms can create niche markets, tailoring their products to specific tastes and preferences and ensuring that even in a crowded market environment, they find a stable position.

Entry and Exit in Markets

Entry and exit dynamics are pivotal in understanding monopolistic competition. Given the relative ease of entering and exiting such markets, these movements greatly influence market stability and firm profitability.

When firms in monopolistic competition make economic profits, they face minimal barriers to entry. This invites new firms to join the market, amplifying product variety and alternatives available to consumers. As a result, the market becomes more competitive.

With increased competition, existing firms experience a shift. The demand for each individual firm's product declines, as new products crowd the market and steal some of their consumer base.

This pressure persists until no firm earns economic profits, achieving long-run equilibrium. Hence, while firms can momentarily enjoy profits, this dynamic self-corrects as the market halts entry when profits are non-existent, regardless of how differentiated their product is. The process of firms constantly entering and leaving the market ensures that, over time, prices adjust to produce a balanced competitive landscape.