Question

Continuing with the scenario in question \(1,\) in the long run, the positive economic profits that the monopolistic competitor earns will attract a response either from existing firms in the industry or firms outside. As those firms capture the original firm's profit, what will happen to the original firm's profit-maximizing price and output levels?

Short answer

In the long run, the positive economic profits earned by a monopolistic competitor will attract a response from other firms, either existing ones or new entrants. As competition increases and firms capture the original firm's profit, the original firm's demand curve will shift to the left, leading to a decrease in its profit-maximizing output level. Consequently, the original firm will experience a decrease in market power, which will force it to lower its profit-maximizing price to remain competitive in the market. Eventually, the market will reach an equilibrium where firms only earn normal profits, and the initial positive economic profits will no longer exist.

Step-by-step solution

Understand the monopolistic competition market structure

Monopolistic competition is a market structure where many firms sell products that are similar but not identical. As a result, each firm has some market power, and they can set their own prices to some extent. In the short run, monopolistic competitors can earn positive economic profits. However, in the long run, those profits attract competition, leading to adjustments in the market.

Analyze the long-run adjustments to the market

In the long run, as other firms enter the market or existing firms expand their production to capture a portion of the economic profit, the demand curve for the original firm's product will shift to the left. This decrease in demand will lead to a decrease in the original firm's profit-maximizing output level.

Examine the effects on price

Due to the increased competition, the original firm will likely experience a decrease in its market power. This is because consumers will have more options to choose from, so the original firm cannot maintain its high price without losing customers. In response, the original firm will lower its profit-maximizing price to stay competitive in the market.

Determine the long-run equilibrium

In the long run, the monopolistic competition market will reach an equilibrium where firms are no longer earning positive economic profits. Additionally, the original firm's profit-maximizing price and output levels will have adjusted in response to the increased competition. This will eventually lead to a situation where firms only earn normal profits, as any positive economic profits are competed away.

Summarize the findings

In conclusion, in the long run, the positive economic profits earned by a monopolistic competitor will attract a response from other firms, either existing ones or new entrants. As those firms capture the original firm's profit, the original firm's profit-maximizing price and output levels will decrease. The market will eventually reach an equilibrium where firms only earn normal profits, and the initial positive economic profits will no longer exist.

Key concepts

Economic Profits in Monopolistic Competition

In a monopolistic competition market, firms enjoy the liberty to control prices due to the differentiated nature of their products. Initially, a firm might experience a period of economic profits, which are returns exceeding the opportunity cost of capital. These supernormal profits act as a beacon, signaling to potential newcomers that there's room for profit in the market.

However, such profits are not indefinite. As new firms are attracted into the industry, the increased competition begins to erode these economic profits. The original firm's unique position weakens as consumers find alternative products that offer similar satisfaction. This phenomenon underscores the dynamic nature of monopolistic competition, where long-term economic profits are not sustainable and will drive the market towards equilibrium.

Market Power

Market power in monopolistic competition allows firms to influence prices through product differentiation. Unlike in perfect competition, where products are identical, monopolistically competitive firms have the leverage to sway customer choices based on unique features, brand identity, or perceived quality. As a result, firms maintain some control over pricing. However, this power is not absolute.

As competitors begin to identify profitable niches and introduce similar offerings, the market power initially held by a firm begins to wane. Consumers empowered with more choices may become less willing to pay a premium for the original firm's product unless it continues to differentiate effectively. This dilution of market power is a critical aspect of the demand curve adjustment process.

Demand Curve Adjustment

The demand curve in monopolistic competition is notably more elastic than in a monopoly due to the availability of substitutes. When economic profits are present, they trigger a realignment of market forces. The resulting entry of new firms or expansion of existing ones causes an adjustment in the demand curve faced by the original firm. Specifically, the demand curve shifts to the left, reflecting a decrease in demand for its product at any given price.

In light of this, the firm must lower its price to maintain sales volumes, which leads to reduced profit margins. Ultimately, the firm will seek a point where its revenue just covers all costs, including the opportunity costs, thereby signaling a move towards long-run equilibrium.

Normal Profits

The concept of normal profits is fundamental in understanding the long-run equilibrium of monopolistic competition. These profits occur when a firm's total revenue exactly equals its total costs, including the opportunity costs of all resources employed. Essentially, normal profits are a sign that resources are being compensated at their opportunity cost and the firm is doing as well as it could by investing resources elsewhere.

In this state of equilibrium, there are no economic profits to entice new competitors, and the allure for existing firms to increase their market presence diminishes. The firm's ability to continue earning normal profits is contingent upon its capacity to maintain the uniqueness of its product without costs escalating beyond what consumers are willing to pay.