Question

If the firms in a monopolistically competitive market are earning economic profits or losses in the short run, would you expect them to continue doing so in the long run? Why?

Short answer

In a monopolistically competitive market, firms will not continue earning economic profits or incurring losses in the long run. This is because the low barriers to entry and exit allow for adjustments in the number of firms participating in the market. These adjustments ultimately eliminate economic profits and losses, and firms end up earning normal profits in the long run.

Step-by-step solution

Understanding Monopolistic Competition

Monopolistic competition is a market structure where a large number of firms sell differentiated products or services. Differentiation can be in terms of product features, quality, branding, or location. Barriers to entry and exit in this market structure are low; hence, firms can freely enter or exit the market.

Short-Run Profits and Losses

In the short run, firms in a monopolistically competitive market can earn economic profits or incur losses. This is because the price charged by a firm (P) is greater than the marginal cost (MC), which results in economic profits. Similarly, if the price is lower than the average total cost (ATC), the firm incurs losses.

Long-Run Adjustments

In the long run, if firms are making economic profits in the short run, it will attract new firms to enter the market. This will increase competition, and the demand for the existing firms' products will decrease. As the demand decreases, the existing firms' prices will also decrease, reducing their economic profits. This process will continue until the economic profits diminish to zero in the long run. On the other hand, if firms are incurring losses in the short run, some can exit the market in the absence of barriers to exit. This exit reduces competition, and the remaining firms will experience an increase in demand and will increase their prices. As prices rise, the losses will slowly lessen. This process continues until the firms are no longer incurring losses in the long run.

Conclusion

So, in a monopolistically competitive market, we do not expect firms to continue earning economic profits or incurring losses in the long run. The adjustments in the number of firms entering or exiting the market will eventually lead to a situation where economic profits and losses are eliminated, and firms just earn normal profits. The primary reason for this convergence is the low barriers to entry and exit, allowing firms to respond to profit opportunities and losses.