Question

(Related to the Don't Let This Happen to You on page 458) A student remarks: If firms in a monopolistically competitive industry are earning an economic profit, new firms will enter the industry. Eventually, a representative firm will find that its demand curve has shifted to the left until it is just tangent to its average total cost curve and the firm is earning zero profit. Because firms are earning zero profit at that point, some firms will leave the industry, and the representative firm will find that its demand curve will shift to the right. In long-run equilibrium, price will be above average total cost by just enough so that each firm is just breaking even. Briefly explain whether you agree with this analysis.

Short answer

The analysis made by the student is partially correct with the process of entry of new firms until the firm's demand curve becomes tangent to the average total cost curve. However, the assumption that firms will leave the industry when zero profit occurs, might not always hold true, especially in the long run. In the long-run equilibrium, contrary to the assertion made by the student, the price will not be above average total, rather it will be equal to the average total cost ensuring the firm is just covering its costs.

Step-by-step solution

Understanding the entry of firms

In a monopolistically competitive industry when firms are earning an economic profit, it is true that new firms get attracted and enter the industry, thus increasing the competition.

Effect on demand curve

This increase in competition tends to shift the demand curve of an individual firm to the left as the consumers now have more options to fulfill their demands.

The tangent point of demand and average total cost curve

The demand curve would continue to shift left until it becomes tangent to the firm's average total cost curve which implies that firm is now just breaking even and not making any economic profit.

Exit of firms and its impact

The assumption that firms will leave the industry when zero profits are being made might not always be correct, specifically in the long run. This is because firms consider their sunk costs and still operate to cover their variable costs.

Long-run equilibrium

In the long-run equilibrium, the price will be tangential to the average total cost, implying the firm is just covering its costs. This contradicts the statement that price will be above the average total cost in equilibrium.

Key concepts

Economic Profit

In a monopolistic competition, firms initially earn economic profit when they offer products perceived as unique by consumers, even though these products can have close substitutes. Economic profit arises when a firm's total revenue exceeds all of its total costs, including opportunity costs. This profit attracts new entrants into the market, hoping to capitalize on the margin, which ultimately increases competition and affects market dynamics.

Firms use profits to innovate and differentiate their products further, but as more competitors enter, the uniqueness and novelty may diminish.

• Increased competition often redistributes market share and decreases the price firms can charge.
• This process leads to a reduction in each firm's market power and profitability over time.

Thus, while economic profits are a driver of entry and innovation in the industry, they are inherently temporary as the market adjusts.

Long-run Equilibrium

In the long run, monopolistically competitive markets tend to reach a state where firms are neither making significant economic profits nor incurring losses—known as long-run equilibrium. In this state, firms adjust to changes over time, incorporating costs and competition into their strategies.

Typically, firms realize that zero economic profit is a natural position they will occupy due to the balance of competitive forces.

• Firms will break even as their average total cost (ATC) curve becomes tangent to their demand curve.
• Long-run equilibrium does not imply firms stop innovating; instead, they continually reassess their cost structures and product differentiation.

It is crucial to recognize that in this equilibrium, firms operate efficiently, even as they yield no surplus beyond covering their opportunity costs.

Demand Curve

The demand curve is critical in understanding how a firm in monopolistic competition adjusts its strategy. It represents the relationship between the price of a good and the quantity demanded by consumers. When new firms enter the market, the demand curve each existing firm faces tends to shift leftward.

This leftward shift reflects decreased consumer demand for their specific product due to increased competition and many similar alternatives available to consumers.

• A leftward demand curve typically means a decrease in potential sales at any given price point.
• This phenomenon forces firms to find optimal pricing strategies to maintain as much historical market share as possible.

As the demand curve shifts, it influences both the pricing strategies and production levels a firm can sustain in the short term.

Average Total Cost

The Average Total Cost (ATC) plays a pivotal role in determining firm profitability in monopolistic competition. ATC is calculated by dividing total costs by the quantity of output produced, encompassing both fixed and variable expenses. It is a crucial benchmark in evaluating firm efficiency and its price setting ability.

When a firm's demand curve becomes tangent to its ATC curve, it signifies that the firm breaks even—covering all costs without earning economic profit.

• A firm seeks to operate at an output level where ATC is minimized, thus achieving productive efficiency.
• Firms that fail to keep ATC in check may suffer losses or fail to attract consumers under competitive pricing pressures.

While ATC guides short to mid-term pricing, long-term survival in monopolistic competition depends on maintaining costs relative to changing demand and competitive landscapes.